FAQs

Why do corporations issue convertible securities?
The ability to convert a corporate bond or preferred stock to a common stock makes it more attractive to the investor. Issuing convertibles allows a company to increase outstanding shares and raise more money than if it had simply issued equity. The convertible raises more cash per new share than an equity would, because investors will pay more for the higher yield and downside protection offered by the convertible. In addition, the interest paid by the company on the convertible is tax deductible, while the dividends on common stock are not. Compared to issuing straight debt, companies can pay a lower coupon, because investors are willing to accept a lower current yield when they also have the option of converting to stock.

Why not just invest in the common stock?
Convertible securities generally have less risk than common stock because they provide downside protection, and they usually produce a higher level of income than common stocks. Convertibles are attractive because of their risk-adjusted returns. That is, for the level of risk taken, convertibles tend to have a high return.

With taxes on dividends dropping, more stocks are paying dividends. Why shouldn't I use dividend-paying stocks instead of convertibles as a source of income?
Convertible securities not only produce income, they also generally have less risk than common stock. In addition, convertible securities are a more dependable source of income than stock dividends. Studies have shown that over a long time period, convertibles tend to offer comparative returns to stocks with significantly lower risk. For investors who already invest in common stocks, convertibles can help diversify their portfolio.

I've heard very little about convertible securities until now. Why?
Convertibles are more complex and require more training to understand than stocks, bonds and mutual funds. Most advisers just don't take the time to learn about convertibles.

What's better - a convertible bond or a convertible preferred stock?
Both have similar characteristics. Preferred stocks pay fixed dividends, so they are "fixed-income" investments, like bonds. The most significant difference between the two is that bondholders receive interest payments before stockholders receive dividend income. When bonds are used, the par is returned at maturity.

What are the tax implications of investing in convertible securities? REITs? Dividend-paying bank stocks?
If any of these three types of securities is purchased through a qualified retirement plan, taxes are deferred. Otherwise, any gains are subject to capital-gains taxes, just like other investments. In addition, dividends from convertibles and bank stocks are subject to a tax rate of 15% for most taxpayers. Until recently, the rate was tied to the taxpayer's income-tax rate. The reduced rate is scheduled to expire at the end of 2008. Dividends from REITs are taxed at the same rate as the owner's income tax, but some dividend income from REITs can be considered a return of capital and is not subject to taxation.