By: Dr K C Gupta

Regular bonds are debt within company capital structures. Bonds are contracts, so, the
bond coupon interest must be paid as scheduled & principal must be paid at maturity to
avoid default. There may be grace periods, waivers by lenders, or restructuring to avoid
defaults in some cases. Often, there is refinancing near maturity that pays the maturing
principal & starts a new debt. In bad economic times, junk or high-yield (HY) bonds nearing
maturities may have additional refinancing risks.

Regular peferreds “stocks” are long-term or perpetual debt (so, fixed-income instruments)
but their dividends must be paid before the common stock dividends, so they have high
interest rate sensitivities. If a company is having financial problems, it may skip preferred
dividends without adverse consequences of default (unlike bonds), but common stock
dividends must also be stopped. Preferreds may be callable. Preferred dividends are
attractive, but know the risks involved.

Preferreds may have “cumulative” features. The skipped cumulative preferred dividends
must be made up before common dividends can resume. Retail investors should buy
nonbank cumulative preferreds. When owners sell their companies, they may accept
noncumulative preferreds as favor to the companies they formerly owned – they get
dividends in good times, but not in bad times; however, the retail investors cannot afford
such generosity.

Banks, however, can count noncumulative preferreds as their Tier 1 capital & issue lots of
such preferreds. So, most preferreds are bank preferreds & they are noncumulative. Retail
preferred investors are stuck, but buying big bank noncumulative preferreds may be safer.
An alternative would be to buy preferred funds (ETFs PFF, FPE, PGX, PFFD).

Because of the priority of preferred dividends over common stock dividends, the name
“preferred stock” is used (never preferred “bond”), but preferred stock is really bond-like
(or, fixed-income) except for bond default. Most preferred dividends are also qualified, so
they are taxed at lower rates.

Now, the convertibles – securities, not cars!

There are convertible bonds (ETFs CWB, ICVT), convertible (noncumulative) preferreds &
convertible cumulative preferreds.

The conversion features state the prices at which convertible bonds or preferreds can be
converted into underlying stocks (nontaxable event). So, convertibles are hybrid securities
as they have features of both stocks (when prices are closer to conversion prices) & bonds
(when prices are far from conversion prices) depending on the level of stock prices relative
to the conversion prices.
Many early-stage, small & speculative companies with low or no credit ratings issue

convertibles because they don’t have access to bank-loans or the regular bond market at
reasonable yields. So, they issue convertibles with lower yields that include some equity
kickers in the form of conversion features.
If these stocks do well, investors or companies convert the convertible debt into equity &
those debt obligations just disappear – imagine that, a loan that they took out just
disappears into thin air (of course, there is some stock dilution, but that can be overlooked
in good times.)

The flipside is that if these stocks tank, then the conversion features have little value, &
convertibles trade like other junk bonds or preferreds; these are called busted convertibles.
In successful turnarounds, investors in busted convertibles can make lot of money while
collecting interest along the way.

Convertibles tend to do well in the late stages of bull markets. Many retail investors are
drawn to them at the wrong times & may get hurt badly in the bear markets that typically
follow the bull markets. Some of these investors may never buy convertibles again, but
there will be new investors in the next bull market. The defensive or “hybrid” features of
convertibles depend on the current market conditions. This is quite different from the
allocation & multi-asset funds that have consistently lower volatilities because they hold
stocks, bonds & alternatives; confusingly, the term “hybrid” is also used for those.

Convertible arbitrage is when institutional investors buy convertible bonds but short the
underlying company stocks to lock in the yields. This is one reason why company stocks
weaken soon after issuing convertibles.

Funds that invest in convertibles do so in a mix of busted & regular convertibles, so these
funds can have income or growth tilts. Only the ETFs have been mentioned here due to
their wide availability, but there are also convertible mutual funds/OEFs & CEFs.
For more information, see https://ybbpersonalfinance.proboards.com/