Dear Mr. Berko: Please explain convertible bonds. We’re in our late 50s. We are not aggressive investors and own a $310,000 portfolio of stocks — mostly utilities and other income stocks — yielding 3 to 9 percent. A stockbroker tried to explain convertible bonds to us, but she just made it more confusing. Could you give us a simple explanation so we can have a clearer understanding? And could you recommend some convertible mutual funds to buy? We have about $21,000 to invest.
— PB, Waterloo, Iowa
Dear PB: Convertible bond investments can be made to appear as complicated as differential equations or as simple as Simon. Sadly, the supposed experts enjoy complicating this subject by using recursive brute force and dynamic programming algorithms to explain how to choose attractive convertible bonds. So I’ll just give you the Reader’s Digest version.
It can be said of convertible bonds that they capture the best of both worlds. They have the safety and income of a plain vanilla corporate bond plus the upside potential of a common stock. Just like regular bonds, CBs are fixed-income investments and pay interest to investors twice a year. But unlike the case with regular bonds, as the underlying stock price increases, so does the market value of the CB. And unlike regular bonds, a CB gives an investor the option to convert his bond into common stock. Unlike common stock, a CB is not worthless if a company declares bankruptcy. CBs can only fall so far because all bonds have prior claims on assets. Another reason is that a CB has a maturity date, at which time the company is obligated to return the par value to each CB holder.
Here’s how it buries. Assume that Associated Bagel & Matzo issues a convertible bond at $1,000 with interest at 5 percent and that it will mature in November 2038. Then assume that the indenture on the ABM bond declares that the bond can be converted into 25 shares of common stock, which doesn’t pay a dividend, any time between now and maturity in 2038. The conversion and break-even price ($1,000 divided by 25) is $40 a share.
