Strategies for Convertible Bonds
Because convertible bonds behave like both a stock and a bond, investors have developed strategies for deciding when and whether to convert the bond into shares of stock. A key factor is the convertible’s market conversion value (i.e., the total value of the shares for which the bond could be converted).
For example, if a $1,000 bond can be converted into 40 shares of stock at $20 a share, the market conversion value would be $800 (40 x $20 a share). Because that’s less than the bond’s face value, the bondholder might well decide to hold the bond rather than converting it to stock, since at maturity the bond would be worth more than its current market price. The stock would have to sell for $25 a share for the conversion to equal the bond’s face value ($25 x 40 shares=$1,000). At that point, the bondholder might begin thinking more seriously about converting the bond to stock.
Like a stock, a convertible bond offers potential for capital appreciation if the stock’s price rises higher than the bond’s per-share conversion price. If that happens, an investor could profit from converting the bond into shares that can be sold for more than the face value of the bond. For example, if the stock in our previous example rose to $30 a share instead of the $20 conversion price, the holder of the $1,000 convertible bond could realize a $200 profit by converting the bond and selling the shares for $1,200 ($60 x 20 shares=$1,200).
When this occurs, the ability to trade the bond for shares at a price that’s lower than the market price also increases the bond’s price on the open market. The difference between the bond’s conversion value and what it can be sold for on the open market is called the conversion premium. The smaller the conversion premium, the more closely the price of the convertible reflects the stock price. Most convertible bonds are callable, meaning the company has the right to redeem the bond early (though many never choose to do so). If the bond is called, the investor generally has approximately 30 days to make a decision about converting the bond to stock.
Tip: Most convertible bonds are issued with call protection for a period of one or more years, during which time the bond cannot be called for redemption.
Caution: Convertibles can be relatively illiquid, and as a result, individual investors may have difficulty finding buyers and sellers for small lots, and end up paying higher prices than larger traders. Because convertibles are not as closely followed as stocks, most are not listed on an exchange.
Strategies for Zeros
Zero-coupon bonds offer a way to lock in an acceptable rate of interest for the life of the bond. Because all the interest on a zero is paid at maturity in the form of the difference between your purchase price and the zero's face value, you know up front exactly how much you need to invest to accumulate the amount of interest needed.
That's why many investors like to use zero-coupon bonds to invest for a specific financial goal for which money will be due at a specific time. For example, you could buy a portfolio of four zero-coupon bonds, structuring their maturities so that one bond matures each year that college tuition is due for a child or grandchild. Zeros can also be timed to mature at designated intervals to provide or supplement retirement income.
Caution: The prices of zeros typically are more volatile than those of similar bonds that pay periodic interest. If you must sell your zero before maturity, you could suffer a loss if bond prices are down.
In some cases, investors like to take advantage of the deep discounts at which zeros are typically sold. For example, if you plan to move into a retirement community in 10 years and know you'll need a substantial initial deposit, you could buy a discounted 10-year zero-coupon bond now so that the funds will be available at the right time.
If you are interested in giving assets to a child or grandchild, a zero allows you to maximize the value of that gift. Because the federal annual gift-tax exclusion amount applies to your purchase price rather than the bond's face value, you can effectively contribute more than $15,000 (in 2020) by giving a deeply discounted zero that would be worth more at maturity.
Caution: Even though zeros pay no interest until they mature, they are taxed as if the owner receives part of the interest each year (except for municipal zeros, which are exempt from federal income tax). If you give a zero, make sure the taxes that will be owed each year aren't a problem for the recipient.
Tip: Because of the taxes on a zero's imputed interest each year, you may want to consider holding zeros in a tax-deferred account, such as an IRA, If you have the option of doing so.
Note: Bonds sold prior to maturity may be worth more or less than their original cost.
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