An Advisor’s Guide to Convertible Bonds and Preferred Stocks

There are a wide range of strategies and securities available for advisors to manage the risk/return potential of their portfolios, but perhaps the least understood are preferred stocks and convertible bonds.

A Breakdown of Convertible Bonds

A convertible bond is a fixed income security that work just like regular corporate bonds but can be converted into common shares of the issuer’s stock. The bond pays interest per its coupon rate, providing guaranteed income until it is converted by the investor, at which point it behaves just as an equity stock would.

These type of hybrid securities offer investors the benefits of both stocks and bonds in one asset and allow for a lot of flexibility on the investor’s end. At its purchase, it functions as any other bond would, with the issuer paying interest (known as the coupon rate) on a semi-annual or annual rate.

When purchased, the convertible bond is issued with a conversion ratio, or a pre-agreed amount of shares that the investor will receive upon conversion to a stock, should they choose to do so. A conversion ratio of 3:1 would mean that a singular bond could be converted into three shares of stock. The conversion price is the face value of the bond divided by the number of stocks it exchanges for.

Convertible bonds allow for investors to benefit in one of two ways, depending on market performance. At issuance, the conversion price is generally higher than the stock price, and therefore, keeping the security as a bond is more beneficial and the income generated from coupon rate makes more sense financially. If, however, stock prices are climbing and the price of shares becomes higher than the conversion price, the option to convert becomes more enticing.

Much of deciding if and when to convert depends on the individual portfolio and the anticipated market environment; in a growth environment, investors may choose to hold off on conversion to try and capture maximum growth and gains when they convert. Alternatively, in environments of drawback or poor performance, the investor can simply hold onto the bond without converting, pulling in interest payments and gaining back the face value of the bond (par value) at maturity.

The Benefits of Preferred Stock

Preferred stocks are another type of hybrid security that combine aspects of bonds and stocks into one asset, but they do not have voting rights included. Preferred stocks don’t pay coupon rates but instead pay dividends based on the par value. While they act like bonds in some regards, they are not actually debt and therefore aren’t repaid back by the issuer at a maturity date.

Preferred stocks are often valued for their tax benefits; the income that is generated from a preferred stock is treated preferentially in regards to taxes because dividends that qualify can be taxed at a lower rate than interest earned on bonds. They are also a type of security that can be converted to common stock — though not every issuer offers convertible preferred shares — with the same kind of conversion mechanics as a convertible bond.

It’s also important to note that dividends are not guaranteed, but in the event of an issuer deciding to reduce or eliminate dividends, common stock dividends are reduced first, offering some potential protections. In the event of bankruptcy, preferred stocks are also paid out before common stocks, although bondholders are repaid first.

Investing in Convertible Securities With QCON

The American Century Quality Convertible Securities ETF (QCON) is an actively managed convertible bond ETF that uses industry diversification with balanced beta exposure to offer the best risk/return potential for investors.

The portfolio managers use a quantitative and fundamental investment process to select securities based on metrics such as earnings growth, sales, profitability, leverage, price momentum compared to peers, valuation, and yield compared to other convertible securities.

QCON has an expense ratio of 0.32%.

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