Convertible Bond Fund Basics

 In financial terms, a convertible bond, also known as convertible note or convertible bond, is an instance of debt where the principal can convert into an agreed amount of stock or a specified fraction of gold in the issuer's portfolio. It's a hybrid financial product with equity-like characteristics and debt-like attributes. For example, it's valued using an asset valuation model. A convertible bond document usually has one or more derivatives, such as interest rates, callable funds, interest rate indexed swap contracts, or credit default swaps.

Convertible bonds are issued by many different companies, both publicly and privately. Common types of convertible bond are bank notes, municipal, corporate, mortgage-backed securities, trust deeds, private placements, corporate securities, and proprietary bonds. These may be structured within the same company, or they may be issued as separate entities. Private placement bonds are company-related, while bank and trust deeds are always considered to be within the private placement category.

Because these instruments are ultimately for sale, it's important to understand their risks and rewards. Debt of any kind carries inherent risks; the risk of default, for instance, is higher with corporate bonds than with individual ones. Corporate bonds don't normally default because the company has the resources to continue making payments, unlike private placement bonds, which often default because there weren't enough buyers. Banks are safer because they typically have sufficient capital to continue making payments; although the exact risks differ from bank to bank. However, both have inherent problems.

On one hand, a debt obligation can provide a company with a potentially very large cash buildup. The cash proceeds generated from a bond offering are typically used to fund the growth and other operating expenses of the company. That means there will generally be a loss in profit and maybe some employees. There also may be dilution of stock; the value of the stock is set before the debt is converted. If the company's stock grows too much, however, the conversion may not take place, and the bond will be repaid.

A bond usually represents a borrower who is pledging a particular company asset (usually a property) as collateral. That means that if the company defaults on its debt, the borrower is able to sell (or simply surrender) his ownership interest in the property in exchange for the outstanding principal. This is referred to as "cashing out." There are different types of bonds, including interest-only, gap, and coupon bond funds.

In a preferred or debt-endowed preferred bond, the company issues preferred stock as a repayment option. The company can use this money to buy back bonds when they mature. Gap bond funds operate in much the same way. Coupon bond funds are a combination of debt and equity. The borrower pays a coupon that represents the amount of interest on the underlying debt.

Most people know about interest-only and gap bond funds. However, there are also funds that combine both types of debt obligations. They make it easy to determine what percentage should go to each obligation. These funds are less complex than mutual funds and allow investors to manage their portfolios efficiently.

You have two basic choices for repaying a bond: you can choose to pay the full amount, or you can choose to pay nothing. No matter which route you take, you will be responsible for any expenses associated with the conversion. Interest-only funds cost more because you only receive the initial premium. Gap funds give you the option of receiving a higher initial yield but costs more because you will have to pay interest on the amount that you save.