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The Advantage of Convertible Bonds
Convertible bonds offer upside potential through capital earnings when the price of stock of the company boosts above the conversion price, and downside protection when market prices of stock drop below conversion value. This because convertible bonds would be valued in no less than the value of bond.
Generally, prices of convertible bonds raise when interest rates decline, which also coincides with the increase of stock prices. This happened in 2003 and 2004, when convertible bonds outperformed the indices of stock market.
On an individual basis, it depends basically on financial factors of the issuing company and the features of convertible bond. Generally, however, if the price of stock of the issuing company continues to increase investors will not do so good with convertible bonds as they would if they bought common stocks of the company instead of convertible bonds.
Some companies do not pay dividends, and when investing in convertible bonds of these companies investors receive regular income flow that come from fixed interest payments before conversion.
Convertible securities offer some protection against inflation due that market prices as for common stocks as for convertible bonds raise with inflation. However, if the price of the market of common stocks does not reach the conversion price and conversion never occurs, then investors do not receive protection whatsoever against inflation because interest payments over bonds are fixed.
Experienced investors can use the convertible bonds to take advantage of the divergent prices in bond and stock markets. This action involves the use of arbitration activities, buying a security and simultaneously selling in short the mentioned security.
For example, buying convertible bonds and selling in short the same can turn out advantageous when discrepancies arouse in prices. A definition of what an arbitration is could help you understand how exploitation of prices of convertibles in the different markets are done.
There is a place for an arbitration when a similar security is bought and sold in different markets in order to exploit its price differentials. For example if the value of the convertible bond in the market is $900, when the price of the stock moves to $24 the arbitrator will exploit this differential in price for his own benefit.
The price of conversion is $960 (40 shares x $24 per share), and the arbitrators will sell in short the stocks.
Selling in short means borrowing a stock and selling it in the market. Simultaneously, arbitrators will buy convertible bonds at $900 while selling in short 40 shares of the stock for $960. The conversion option in the convertible bond is exercised and the shares that were borrowed are tendered. The resulting earnings will be $60 per bond before commissions are taken into account to be paid for buying and selling the securities. Through this action arbitrators bid up bond prices until there is no differential price. In reality the price of the convertible bond is rarely the same conversion value in stock. Prices of convertible bonds exceed, mainly, the value of conversion due to the value of the bond.
Besides the upside appreciation due to the conversion value, the value of the bond as debt provides a floor price for the convertible bond.