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ETF Specialist

Are Convertible Bonds the Best of Both Worlds?

Convertible bonds possess positive traits of both debt and equity, but they come with their own perils.

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What Is a Convertible Bond?
Like a regular bond, a convertible bond pays coupons, but this security gives investors an option to convert the debt into equity if the issuing company’s share price rises above a prescribed price. These hybrid securities are senior to equityholders during bankruptcy proceedings but usually subordinate to traditional bonds.

Convertible bonds have different return patterns depending on how the underlying common stock has performed since the issuance. If a convertible bond's corresponding stock price is below the conversion price, it is valued like a straight bond with an out-of-the-money call option attached. As the stock price reaches or surpasses the bond's conversion price, this instrument will begin to trade in line with the stock, allowing the investors to participate in the stock’s upswing.

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