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Making Sense of Convertible Bonds and Where to Find Them

This niche corner of the bond market may be worth a look.

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Convertible bonds can be an attractive option for investors looking to supplement their income needs without sacrificing growth opportunities. These hybrid securities incorporate both bond and equity features. They have an embedded call option that provides the holder the right to convert the bond into common stock of the issuing firm at a predetermined (conversion) price. But if the stock price tumbles, the convertible’s interest and principal payments help limit losses.

As a result, convertibles tend to be correlated to equities, experiencing some but not all of the equities' upside with less of the downside risk. Still, this profile can vary given the different types: These bonds can be busted, equity-sensitive, or balanced. Prices for busted convertibles are below the securities' par value, and they tend to act more like a corporate bond while equity-sensitive convertibles have prices above par and tend to trade in tandem with a company's common stock. Balanced convertibles exhibit characteristics of both, leading to the asymmetric profile that many investors favor. These hybrid securities are senior to equity in the capital structure but usually subordinate to traditional bonds.

Zachary Patzik does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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