Which Convertibles Can You Drive And Which Can You Use As Investment Vehicles?

You’re blasting down the interstate in your BMW i8 Roadster convertible.  This is one awesome ride. You put the pedal to the metal, and this baby purrs like a kitty at 140 MPH. But hey, what if you want something bigger with more bling? How about a Mercedes AMG S-65, the top of the line S Class? This will only set you back a mere $247,900.  A Corvette Stingray convertible? C’mon, get into the 21st Century. Sure, they still make them, but anyone can afford one at the MSRP of $55,495. 

Nonetheless, you couldn’t resist the i8 BMW Roadster convertible. While palming your Bimmer down the highway, you come upon three convertibles hitching a ride to Vegas, so you stop and pick them up. Back on the road, you ask, “who are you guys?”

The biggest of the three clears his throat and says, “I’m a convertible bond.”

“Cool. We’re riding in one.”

“No, I’m not a convertible. I’m a convertible bond.”     

“Cool. Never heard of you but I’m an investor. Just bought 100K of a cryptocurrency, LexLutherKrypton. I know what I’m doing. Lay it on me.”

The three guys exchange pained looks, then Mr. Convertible Bond speaks. “I will give you the formal definition According to the U.S. Financial Industry Regulatory Authority (FINRA).  

“Convertible bonds offer holders the income of regular bonds and also an option to convert into shares of common stock of the same issuer at a pre-established price, even if the market price of the stock is higher… As a tradeoff for this conversion privilege, convertible bonds typically yield less.” ¹

You roll this around in your head for a minute. “What I think you mean is, if I buy a convertible bond I can convert it into common stock of that company at a specific price even if the stock is above that price?”

“That’s the idea. Investors buy me because they like the company and they get paid interest on the bond while waiting for the stock price to go up although a convertible preferred stock can do many of these things as well.”

Hmmm. This is slightly confusing. “What are convertible preferred stocks?”

The second guy speaks. “That’s me. Just like a convertible bond, you can convert me into common stock of the corporation when, and if, the common stock of the corporation reaches a certain price or on a certain specified date. Depending on your tax situation, especially if you are a corporation, you may receive special tax treatment on my dividends. Further my dividend is fixed at a certain percent, so you know what you are going to get.”

“What’s the difference between the bond and the stock?”

“Taxation. Rate of return. Flexibility. All these can be different. Plus, many, but not all preferreds are cumulative. Therefore, if the company suspends the dividend on their preferred to save cash, once they start to pay the dividend again, they have to pay you all the dividends in arrears.”

This sounds appealing. You meditate on this issue while listening to stress relaxation music played on bamboo flutes. You hit 150 MPH without even knowing it. You look at the speedometer and gently tap the brakes.

Who is guy number three? You notice he is the only person in the car not wearing a seatbelt. “Guy number three, who are you?”

“I’m a convertible note.”

“So, you’re not a bond, you’re not a stock. You’re a note?”

“I’m just an innocent note,” he says, with a slight tone of malice.

You ask him to explain himself, and he tells you that convertible notes are loans made to start-ups which you can later convert to equity when the company issues stock.

You want a more exact answer. “Let’s call FINRA and ask them.” So, you do. This is what they say.

“Convertible notes are another type of security that has been offered in crowdfunding opportunities.  Convertible notes are essentially debt obligations in which the investor agrees to loan money to the company.  In exchange, the investor receives a promise of repayment, interest on the loan for a period of time and an ability to convert the outstanding amount into equity of the company at some triggering event.” ²

Good to know. You come over a rise and see a huge blinking sign.

“Welcome to Las Vegas.”

“Hey, you guys, do you ever think how much the financial markets resemble casinos?”

“That’s not funny, and no, we don’t.”

“Dudes, chill. I’m interested in this whole preferred thing. But I don’t want to do the research and figure this all out. Can’t I buy a fund or something?”

“Yes, you can,” the three chirp.

As always, you as a Financial Adviser can serve as a resource to your clients on these investment vehicles.

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Resources: 

1  http://www.finra.org/investors/corporate-bonds

2 https://www.sec.gov/oiea/investor-alerts-and-bulletins/ib_safes

Contributing writer: subject matter expert Charles McCain