IT is always interesting to watch the making of a movie — looking at the inspiration and motivation that led to the making of the movie, interviews with the producers and project creators to hear the who, what, where, and how is always the best part of the story. As interesting as this is to explore, let us delve into greater details behind the scenes of convertible bonds.

A convertible bond is defined as a bond that the issuer can convert into shares (ie equity) or cash of equal value at a predetermined price and or time. Once converted, the holder of the investment is given shares in the issuing company. The terms and conditions for the conversion will be outlined in the indenture, spelling out the number of shares or the method for calculating the number of shares to be allocated to each investor. In addition, the issuer may stipulate that the conversion rate may change over the years, of course this information will be detailed in the indenture so that investors are fully aware. This type of instrument has features of both bonds and equity as the investor starts out being a lender of the company and can end up being a shareholder (owner of the company).

Types of convertible bonds

There are a number of different types of convertible bonds available, however our only mention are of the three main ones:

* Mandatory Convertible

These bonds can be converted to stock either prior to maturity or on the maturity date.

The interest rate on these bonds is usually higher than other convertible bonds in order to compensate the investor for the smaller capital gain that they are likely to earn if the bonds are converted before maturity.

* Contingent Convertible

These bonds are converted into stock only when the stock reaches the price that is outlined in the indenture (predetermined price). The indenture for these bonds may also stipulate that the stock remains at or trade above the contingent price for a specified time period.

* Vanilla Convertible

These bonds are converted to stocks when a specific event occurs or at a specified price (which would be outlined in the indenture). The bonds cannot be converted if the predetermined conditions are not met.

Why invest in convertible bonds?

Convertible bonds offer investors the attractive features of a bond such as regular coupon payments while also providing exposure to equity and the possible price appreciation associated with both the stock and the bond. Convertible bonds also usually offer higher coupon rates than other plain vanilla bonds.

There are investors who are hesitant to invest in stocks; convertible bonds offer them an alternative to enjoy the benefits of a bond while watching the stock of the issuing company to see how it performs. If the stock trades up then the investor may choose to convert the bonds into stock (some convertible bonds gives the investor the right to convert the bonds).

Drawbacks

Unfortunately, the stock price has to reach a predetermined price before the bonds can be converted. The price may be set at a very high price, given current market conditions. Therefore, if an investor would prefer to hold the stocks right away it may be easier and cheaper to invest right away in the stock instead of waiting until the high trigger price is reached.

Also all convertible bonds are callable by the issuer, which mean that if conditions are favourable for the issuing company they will convert the bonds into stock at their own discretion.

Before investing in convertible bonds one should get the full blueprint on the product. This investment is geared towards clients who are investing for the medium to long-term (as they tend not to be as liquid as plain vanilla bonds) and clients who are interested in holding the stock of the issuing company. This investment product offers investors the opportunity to a fixed amount of interest and possibly to participate in the stock market. Speak with a financial advisor about the full story of convertible bonds and ensure that you understand all the intricacies before you make the investment.

Dian Blackwood is Manager, personal financial planning with Sterling Asset Management Ltd. Sterling provides medium to long term financial advice and instruments in US and other world market currencies to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net