Both bonds and stocks offer various advantages and drawbacks. This year, those drawbacks include falling prices for bonds in the face of higher interest rates and the threat of sharp pullbacks from record-high stock prices. So what’s an investor to do? One alternative, called a convertible bond, combines some attractive features of bonds and stocks while offering extra protection.
What they are: Convertibles start out as corporate bonds, providing investors with annual payments at a fixed annual interest rate, called a coupon, and typically maturing in five to 10 years. They also give bondholders the right to exchange the bonds for shares of stock in the company that issued the bonds at any point before they mature. If the investor chooses to “convert” the bonds to stock, they are swapped at a fixed ratio specified when the bonds are issued—for instance, 20 shares of stock for each bond.
The attraction: If the stock price rises high enough, the investor can take advantage of that increase by converting the bonds to stock, thus increasing the value of the investment. If the stock price does not rise high enough or falls, the investor can hold on to the bonds and keep collecting income.
As a result, convertible prices are not as volatile as stock prices. Convertibles tend to gain about two-thirds as much as the company stock during rallies and fall about half as much during slumps. Drawback: Interest rates that companies offer on convertibles tend to be lower than for regular bonds.
Best bond funds: Vanguard Convertible Securities (VCVSX), three-year annualized performance: 11.2%…SPDR Barclays Convertible Securities ETF (CWB), an exchange-traded fund, three-year annualized performance: 9.8%.