There are always people who are ready to advise you to stay out of the market altogether. "The market is just too high for anybody to stay in," they say. On the other hand, loyal followers of common stocks, especially the growth-type stocks, insist that common stock is the only vehicle for participation in the nation's explosive growth. This historical piece offers some great insight.
For those who are neither willing to go all out for common stocks nor resigned to stay away from the market altogether, convertible bonds may be an ideal solution.
A convertible bond or convertible debenture bond has two major investment appeals: limited risk of price decline and the possibility of important price appreciation. It is just about the surest thing in characteristically unsure Wall Street. This is especially so when the market looks bad; this would be the time for investors to turn to convertible bonds as a means of obtaining protection against capital loss while maintaining a potential equity position through the conversion features of this type of obligation.
The two primary conditions for buying convertible bonds are, first, selling at moderate premiums above their value as investment and, second, possessing attractive appreciation potential based on favorable long-term prospects for the equities into which they may be converted.
The former is important because bonds may prove almost as vulnerable as their underlying stock if they should be selling well above their face value. The latter is important because the price of convertible obligations is not likely to appreciate in a basically weak company.
The value of a convertible bond or convertible debenture must ordinarily lie within a region specified by two limits. At the lower limit, is the straight debt value of the debenture, while at the upper limit lies the conversion value as determined by the current market price of the common. It is possible for the conversion value of the common to fall below the straight debt value, but in this case the value of the debentures would most probably settle near the straight debt value.
To sum up, the value of the debentures has a fairly stable lower limit, but an upper limit normally restricted only by the value of the common. Analysts called this lower limit a "theoretical floor" below which convertible bonds are not expected to decline in the event of further weakness in the common stocks to which the bonds are convertible. This floor is the estimated value of the bond without a conversion privilege. Of course, the estimated investment value changes with the fluctuations in interest rates. As interest rates rise, the investment value declines, and vice versa.
No one can expect a safer investment than one which has almost unlimited potential for upside movement while its downside risk is virtually limited by the straight debt value of a bond.
"The upside potential in a convertible bond," in the words of a Goodbody & Co. study, "depends upon the leverage in the conversion privilege, the closeness at which the bond sells to conversion parity, and the extent of the rise in the common."
The Goodbody study explained the "conversion privilege" as a "leverage" in the following example. Said Goodbody: "If a $1,000 bond is convertible into 20 shares of common stock and the common sells at 50, the conversion parity for the bond would be 100. Under these conditions, and assuming the bond is selling around 100, each point rise in the common stock would result in a two point rise in the bond."
Interested in investing for yourself? Do your homework, ask a respected professional, and make educated decisions to make the most of your investment dollars.