Chameleons are the introverts of the animal kingdom -- they only show off when they're mad or scared, and they walk funny so that everyone else thinks they're tree branches blowing in the wind.
This helps them avoid peacocks, monkeys and other loud, showy extroverts that are generally very draining to be around. The true beauty of a chameleon, of course, is its ability to change color. It prevents them from being eaten.
One group of investments -- convertibles -- are like the chameleon. Because they have options attached, they let you fly under the radar and then turn into something else when the market turns, or you just feel like hiding out somewhere else.
Here are four big ones that you should know about.
A convertible bond allows you to exchange it for other securities (usually the issuer's stock). You use the par value of the bond to purchase those other securities from the issuer at a specified price.
Consider a Company XYZ bond with a $1,000 par value that is convertible into Company XYZ common stock. If the conversion price is $25, that means you can convert your bond into 40 Company XYZ shares ($1,000 / $25 = 40).
That's good if the market price of the shares is, say, $35. You get to buy shares for $25 and sell them for $35, netting a $10 profit. This is an important point, because it means that if the stock tanks, you don't suffer the way stockholders do. You still get your coupon payments and still have priority over stockholders if the company liquidates.
However, many convertible bonds are callable, meaning that under certain circumstances the issuer can pay them off early. This creates reinvestment risk, which is the chance you'll be stuck reinvesting your returned principal at a lower rate. And because conversion means giving up coupon payments, you have to compare the coupon rate to the dividend yield if you're thinking of converting.
Callable Certificate of Deposit
A CD is a time deposit with a bank or financial institution for a fixed amount of time (usually six months, one year or five years) in return for a specified interest rate. When the CD matures, you get your original principal plus the accrued interest. A callable CD gives the issuer the right, but not the obligation, to redeem the CD before it matures.
For example, consider an XYZ Bank CD issued in 2000 and maturing in 2020. The indenture might say, “The XYZ Bank CD due June 1, 2020, is callable on June 1, 2010, at a price of 102% of par.' Note that the call premium usually decreases the closer a callable CD is to maturity. That 102% price in 2010 may fall to 101% in 2015. Many callable CDs don't pay call premiums.
Callable Common Stock and Callable Preferred Stock
Callable common stock and callable preferred stock (also called redeemable preferred) give the issuer or a third party the right, but not the obligation, to buy your stock at a specific price after a certain time.
Let's assume you own 100 shares of Company XYZ callable common stock. If the stock is callable at 105% of market price and the shares are trading at $100 per share, then Company XYZ could force you to sell your shares back at $105 per share ($100 x 1.05).
The price of callable common stock is affected by whether the call option is in the money. For example, if the stock is callable at $100 and the shares are trading very close to that (say, at $99), the issuer is more likely to call the stock than if it were trading at $89. Investors know this, and so the stock's price is effectively capped at $100.
Most callable preferred stock has a sinking fund provision, which requires issuers to set aside funds specifically for retiring a portion of the issue over time. Additionally, preferred stock usually pays a dividend, so having a stock called away can be daunting for income investors.
The Investing Answer: Convertible securities are hybrid securities; that is, they share the characteristics of two kinds of securities (in our examples, stocks and bonds).This can create more volatility in the price of these securities, but it also allows holders to participate in price appreciation on two fronts. However, callable securities carry reinvestment risk. Thus, callable securities tend to offer higher returns than their plain vanilla counterparts.
