www.InvestmentGuide.co.uk www.InvestmentGuide.co.ukShares A Beginners Guide to Making Money Contents
Buying a convertible loan stock is the closest you can get to an each-way bet on the stock market.
The convertible is a form of loan stock paying a fixed rate of interest, but with the option to convert into ordinary shares on a specified date or between specified dates.
For example, supposing you pay £100 XYZ convertible loan stock 10% 2010. This will give you a regular 10% interest a year, but with the opportunity to convert into ordinary shares in the company at the rate of three ordinary shares for each £1 stock held on June 1, 2005.
If by 2005 the ordinary shares have risen to, say, £1 each it will obviously pay you to convert and you will have trebled your investment.
On the other hand if the ordinary shares have fallen you can keep the stock and receive the regular 10% yearly interest until the redemption date in 2010. The company will then buy back the stock at the original issue price of £100.
You don't necessarily have to hang on to the stock until the conversion date to make a profit. The price of the convertible moves in line with the price of the ordinary shares, based on the underlying value of the terms of the conversion. But the movement is more moderate in each direction.
Because of its defensive qualities, (because it falls less when prices fall) the price of a company's convertible stock is normally higher than that of its ordinary shares at the time you buy.
Taking the earlier example, let us assume that XYZ ordinary shares are standing at 25 p each today. For every £1 you invest, you could buy either four ordinary shares or £1 convertible stock. Remember, the latter is exchangeable for three ordinary shares in 2001. You are therefore effectively paying 25p extra for the company's convertible stock; this is called a premium.
This premium is often quoted in percentage terms. It is calculated by taking the difference between the conversion price and the current share price and dividing it by that share price. In our example the conversion price is 33.3 p and the current share price is 25 p which gives a premium of 33%.
Obviously, you stand to make more money by buying the ordinary shares, but they are riskier. If their price tumbles you are not protected by the high-interest yield or the chance to get the original issue price back in 2010, as you are with the convertible.
Of course, you are unlikely to get in on the ground floor and buy a convertible at its issue price as in our example. If you pay say £120 for £100 XYZ convertible stock you will only get £100 back in 2010.
The attraction of convertible stock is that it provides you with a comparatively high interest yield - normally far in excess of the ordinary shares - and at the same time offers the chance of capital growth.
The best way to choose a convertible stock is to concentrate on the underlying shares. Pick a company you like and then check whether it has issued any convertible stock. Never buy a convertible in a company you are not enthusiastic about simply because the stock offers a high yield.
Dealing costs are about the same as for ordinary shares and the spread (the difference between the buying and the selling price) is little different from that on the equivalent ordinary shares.
Convertible preference shares
There are also a few convertible preference shares on the market. The main difference between these and convertible loan stock is that convertible preference shares are not redeemable at the end of their lives. If you keep them until the last date your only option is to convert them into ordinary shares; you cannot get the issue price back.
Bargain hunters
A share price will rocket and investors may sometimes forget about the convertible. So, instead of a premium the convertible is obtainable at a discount, providing a cheap way into the ordinary shares. It doesn't happen often and you have to be very quick to snap up such a bargain.
Last updated 19
January 2008.