Should you buy convertible bonds?

What is a convertible bond? Bonds and shares are best considered as separate investments. However, a convertible is a hybrid combining a bond with a call option (see below). You start off by owning an IOU, a bond that usually pays a fixed rate of interest.

Then, at a later date or a series of later dates you have the right (via the call option) to convert the bond into shares at a set price. This is done at a conversion ratio that specifies what every £100 of the bond's nominal value is worth in shares.

The win-win scenario

A convertible bond can be a winner both for the firm issuing it and the investor. For the issuer, by offering the potentially valuable opportunity to a holder to convert to shares later, the initial coupon paid can be lower than on a conventional bond.

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As the FT's David Stevenson points out, the Aberdeen Asian Smaller Companies Trust (LSE: AAS) and the Edinburgh Dragon Trust (LSE: EFM) recently tested the market with convertibles paying around 3.5%. Conventional bonds can be bought via the London Stock Exchange's retail order book paying coupons that are 50% higher. Plus, if the holder opts to convert, the issuer saves a big cash outflow when the bond matures bonds are redeemable and shares are not.

As an investor, the upsides are a regular, if unspectacular, coupon from the convertible, plus the chance to convert to shares later. Whether this is a good bet depends on where the issuer's share price ends up in relation to the fixed strike (conversion) price.

Say you buy a bond with a conversion price of 350p while the issuer's shares trade at 320p you're better off buying the shares. However, if at the conversion date the shares trade at 370p, your right to convert at 350p provides an immediate 20p per share gain plus the chance to enjoy any dividends and capital growth thereafter. You can access part of the potential upside from share ownership, but without the same level of risk.

How it could go wrong

If the issuer's share price never hits the conversion price you may be stuck with a lower yielding bond. And convertible bonds are not risk-free. Convertible debt ranks behind bank debt and corporate bonds. If an issuer goes bust, you are not guaranteed a repayment, albeit you stand a better chance than a shareholder.

Why buy now?

Convertibles are not portfolio building blocks they should be small add-ons. However, they combine the chance to earn a steady and fairly secure income along with some sharp upside should share prices lift off. They are a safer bet than shares and much safer than buying call options on shares outright see below.

What to buy

For retail investors, buying single convertible bonds issued by non-investment companies is tricky as the choice is limited and they can be risky and/or awkward to buy unless you are bond-savvy. There are also few to choose from. A better bet is a fund. The cheapest options are exchange-traded funds, but the best-known names, such as Barclays Capital (NYSE: CWB) and Powershares (NYSE: CVRT), only offer US-listed products.

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To avoid currency issues, the best option is to buy via an investment trust. In the last year around £130m of these instruments were launched with more on the way. While not for widows and orphans trusts that issue convertibles are usually geared towards smaller, riskier companies in need of capital this route gives you the best shot at the sector.

Standard Life UK Smaller Companies (a strong performer over three years with a rise of 117%), for example, offers a 3.5% convertible bond (current yield around 3.3%) with a conversion option in 2018. "If I had to rely on anyone to deliver sizeable capital gains in the next six years," says Stevenson, Harry Nimmo at Standard Life would be on his short list. The new launch from MoneyWeek favourite Aberdeen Asian Smaller Companies Trust, run by Hugh Young, could also be worth hanging on for.

What is a call option?

Call options give the holder the right, but no obligation, to buy a specified number of shares at a pre-agreed strike price at a future date (European-style and usually cheapest), by a future date (US-style and pricier), or on a series of future dates (Bermudan-style and priced somewhere in between).

The price of this flexibility is a premium, paid upfront and non-refundable. It's a use it or lose it deal if the holder does not exercise the option, the premium is lost, so the possible downside is 100% of the sum invested.

However, if the underlying share price surges past the fixed strike price, the option is said to be in the money'. Whether or not it is profitable overall depends on the size of the premium paid. For example, if a call option has a strike of 250p and costs 30p per share, the underlying share price needs to rise to at least 280p (250+30) before the option makes money.