Convertible bonds (convertibles) can help investors improve the balance of risk and reward in their investment portfolios.

Convertible bonds, or convertibles, are a cross between a fixed income security and a company share investment and, as such, can be a relatively low-risk investment when compared to asset classes such as company shares. Convertibles are structured in a similar way to corporate bonds (fixed income securities issued by companies) in that they generally pay a fixed rate of interest and have a fixed date when they will be repaid.

However, the difference is that convertibles can be exchanged for a fixed number of company shares. This gives you the opportunity to benefit from rising stock prices for better long-term returns.

The value of investments will fluctuate, which will cause fund prices to fall as well as rise and you may not get back the original amount you invested.

How do convertibles work?

Convertible bonds pay a regular coupon payment (the interest paid by the company that has raised a loan by selling the bonds) and have a fixed maturity date (the date at which a bond is contracted to be repaid). However, they also come with an option that allows investors to convert them into a certain number of company shares.

This can be done within a set time period and at a specified price, called the conversion price. As the share price of the underlying company increases, the value of the associated convertible also increases.

Why own convertibles?

Convertibles can help diversify your portfolio by improving the balance between risk and reward. This is because they respond to market events differently to both bonds (a loan, usually taken out by a government or company, which normally pays a fixed rate of interest over a given time period, at the end of which the loan is repaid) and equities (shares of ownership in a company).

For example, over the long term, convertibles typically produce similar returns to those of equities. But while the returns are similar, the risk is lower. Owning convertibles can therefore help to spread overall risk within an investment portfolio.

Convertibles are usually less volatile (when the value of a particular share, market or sector swings up and down fairly frequently and/or significantly, it is considered volatile) than equities. If share prices rise, you will benefit, and if share prices fall, you will still have some downside protection.

Most convertibles also benefit from yield (return on an investment over a given period, typically 12 months, relative to the current price of the asset) advantage. This means they pay you a fixed income stream that tends to be higher than the dividend yield to a shareholder of common stock.

Finally, convertibles enjoy a higher ranking than common shares within a company’s capital structure. In other words, you would have a claim on the assets of the underlying company and would receive a higher recovery value in the event of bankruptcy or liquidation.

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