Convertible Bonds: Understanding How They Work

In Chapter 16 of The Intelligent Investor, Benjamin Graham explores the world of convertible issues, namely convertible bonds and convertible preferred stocks. He also discusses stock-option warrants.

This article is part of a series on Understanding The Intelligent Investor. It continues from the Chapter 15 review on beating the stock market with proven strategies by Joseph Hogue, CFA at My Stock Market Basics.

One of the most important lessons in this chapter is the idea that Wall Street often spins the value of products to favor the commissioned-based seller and issuing company. Instead of relying on advisers or sellers to identify an attractive product, the discerning investor could do well to fully understand both the advantages and disadvantages of investment products.

Let’s delve into convertibles and discover what Graham thinks of them.

Bond Investing Terms: The Basics

One of the shortcomings in my investment knowledge has been bonds. As a business major, stock investing — buying shares of a publicly traded corporation — has been intuitive. Investing in bonds has seemed more mysterious, largely because of the different types of bonds and the lingo unique to this investment genre.

I’ve held bond funds in my portfolio but they’ve underperformed my stocks by a large margin and failed to provide stability to my portfolio. As I prepare for retirement and more passivity in my portfolio management, I plan to become a better investor particularly in the realm of diversification. Understanding bonds is an essential part of this process and so I’ve begun to delve into this area.

Buying an individual bond is like making a loan to a government or corporate entity. I invest money in return for interest and payback of principal by the borrowing entity at the end of the loan term. The presence of a secondary market (see below) makes bond investing more complex. Understanding common bond investing terms is the foundation of grasping bond investing.