The Cons of Convertible Bond Investing

When markets are volatile, investors love a good hybrid security. Give them the stability of debt and the potential upside of equity, and they tend to feel a lot better about handing over their money to growing companies-which explains why convertible bonds had another great year in 2003. The amount raised in new convertible bonds-$85.6 billion-was the second highest in history, according to a December 2003 Morgan Stanley research report.

In 2003, smaller companies in particular benefited from the surge in convertible activity. According to the report, the percentage of convertible new issues from small-cap companies increased dramatically-from 46.7 percent of the total in 2002 to 63.9 percent in 2003-while the percentage of new issues from S&P 500 companies fell to 24.1 percent from 42.8 percent. Convertible bonds are essentially debt with a twist: In addition to getting steady interest income, the investor has the option to convert the debt to equity by buying the company's stock at a fixed price in the future.