I sometimes answer questions for those at Klout.com that ask basic investing questions. ?Usually I point to old articles of mine, but this time someone asked a question that I have not answered before, and here it is:

What’s a convertible note? I’ve Googled for the answer but can’t find a simple answer. Why would one take a note when investing rather than equity?

Some people want the best of both worlds. ?I want upside potential, but I want a guaranteed downside where I still make money. ?That’s a convertible bond (or note, same thing). ?The convertible bond promises to pay you income though interest payments, but allows for the possibility that you will want to exchange the bond for a fixed number of shares in the company. ?When would you want to do such an exchange? ?You would exchange when the stock price rises to the point where the bond is worth more converted into stock.

Let’s look at this question from the other side for a moment. ?Why would a company issue a convertible bond? ?There are several reasons:

• Typically, companies that issue convertible bonds have credit ratings that are junk or low investment grade. ?They want a low interest payment for a company of their credit quality, and so they trade potential issuance of more stock at a time where it would hurt, for lower current interest payments.
• Often, the companies that offer convertible bonds are growth companies that need capital, but they might have a hard time doing an ordinary junk bond. ?Convertible bonds have a ready buyer base.
• Convertible bonds can be the “financing of last resort” for companies that are in financial trouble. ?(Article one, article two)

Now, many convertible bonds are issued by companies that subsequently don’t do well, and the bonds get bought by junk bond managers who buy them as junk bonds — they are called “busted converts.” ?They trade as if there is no conversion option, and some clever junk bond managers buy them, knowing that if a few of them have stocks that rally significantly, they will make enough extra money to aid their performance.

For what it is worth, the same ideas apply to convertible preferred stock, except that is bought primarily by individuals, while the bonds are bought by institutional investors. ?Also note that preferred stock has weaker credit quality than bonds. ?In liquidation, bonds get paid before preferred stock.

Final Notes

Convertible bonds changed when hedge funds emerged to invest in cheap convertible bonds, because the conversion option was frequently undervalued. ?As they became a larger force in the market convertible bonds rose in value, until they were largely not attractively priced.

Prior to that era convertible bond funds regularly outpaced other bond funds. ?They behaved kind of like a funny type of balanced fund.

As an investment grade corporate bond manager, I bought a convertible bond once, where it was “busted,” and was attractive just for the income alone. ?As it was, after I left the firm, the stock rallied to the point where converting to stock made sense.

This is tough: convertible bonds make sense for those that want the possibility of extra income if the stock price rises, but are willing to take a lower income on the convertible bond versus straight debt.

Oh, one more thing, again, generally only lower rated companies issue convertible debt, so you have to live with a higher level of default risk. ?Yes, convertible bonds offer the best of both worlds… so long as the issuer doesn’t default.