In a renewed commitment to finally learn Spanish, one of my colleagues spent quite a bit of time this week awkwardly saying, “Qué es eso?” into the headset Rosetta Stone provides with its language learning programs. Translation: “What’s that?”

Here in the US, the 10,000 or so people reaching retirement age each day often find themselves asking the same question—though maybe not out loud—when advisors use terms of art or casually mention sophisticated investment options. What’s that? Most of these folks didn’t earn their living in the financial services sector, so they don’t speak the language—nor should they feel embarrassed about it.

That said, no one—particularly risk-adverse retirees—should ever invest in something they don’t understand. So let me add one more type of investment to your “I know about that” toolbox: convertible bonds. Despite their obscurity, they’re not the least bit complicated.

Put simply, convertible bonds:

  • have, as a rule of thumb, two-thirds of the upside of common stock and one-third of the downside; and
  • can be an excellent way to diversify your portfolio.

Convertible bonds are bonds an investor (let’s say it’s you) can convert into common stock of the issuing company under certain circumstances. Imagine, for example, that Rosetta Stone wants to finance a new project—maybe it’s doing R&D on how to teach humans to speak the language of chimpanzees (hey, this is purely hypothetical). So Rosetta Stone (RST), which has a current stock price of about $8.75, issues a convertible bond and sets the conversion rate so that it’s not profitable to convert your bonds unless the stock price rises, say to $11.

Then more people start to feel a burning need to learn Spanish—or Mandarin, or Farsi—and RST’s price passes $11. At that point, you can convert your bonds into shares of RST worth more than the stream of payments from the bond alone. You own bonds with upside potential.

If RST’s price goes up, the value of your convertible bond goes with it. If it goes down, the discounted stream of underlying cash flows (the bonds’ coupon payments plus return of the principal at maturity) act as a price floor.

Now imagine that speaking multiple languages goes out of vogue, and instead of rising past $11.00, RST drops to $4.00. You’ll still receive interest and principal—meaning your convertible bonds can’t be worth less than those payments.

Of course, there’s always the threat of default. Say Rosetta Stone goes bankrupt for one reason or another (maybe it overspent on the chimp project, and it failed). The silver lining is that you’ll have a better chance of getting some money back than if you owned common stock.

What You Trade for the Option to Convert

As with any investment, there are tradeoffs: convertible bonds have slightly lower yields. The company pays a lower interest rate, and in exchange you have the option to convert your bonds. Also, convertible bonds often fall into the high-yield/junk-bond category.

What’s more, it’s often only feasible for individuals to invest in convertible bonds through convertible bond funds. And you know what that means: fees. With an average expense ratio of 1.25%, fund managers have to get past that hurdle before they can start making you money.

With that, why would anyone want to buy a convertible bond fund? In a word, diversification. We hold one convertible bond fund in our retirement-specific portfolio for downside protection and the diversification it provides via 97 investments, including a 37% allocation to the technology sector and 17% to consumer noncyclical. With a gross expense ratio of 0.4% and one-third of its holdings in investment-grade bonds, this particular fund avoids the major pitfalls of convertible bond funds.

Less common investments are worth knowing about, but understanding them doesn’t mean you should jump in whole hog—particularly when you’re investing a nest egg you can ill afford to lose. The fund we hold is the one and only convertible bond fund that’s passed muster with our team, and we’re quite pleased with how it’s performing: up 22% in the Money Forever portfolio as of our August publication date. We’re still recommending it as a Buy, but of course, I can’t shout the fund’s name from the rooftops.

If you haven’t done so already, sign up for a 3-month Money Forever trial subscription to learn more about our favorite convertible bond fund. You’ll get immediate access to our complete portfolio, our full library of special reports, and all of our back issues.

Read through the material, and if it’s not for you let us know within 90 days, and we’ll return every penny you paid. Click here to subscribe to Money Forever now.

On the Lighter Side

Football season is upon us. College football began last week, and the National Football League season begins this weekend. It’s the true sign of fall.

Meanwhile, in the world of baseball, my beloved Chicago Cubs have brought up a bunch of kids from the minor leagues. While the Cubs have been out of the race for several weeks, they are playing contenders for most of September and are enjoying playing the role of spoiler. Like a lot of Cubs fans, I look forward to the day they play meaningful games in September.

My colleagues in Stowe have opened up the Casey OnePass window until Friday, September 12. If you’re a serious investor, this is a limited opportunity to subscribe to all of Casey Research’s newsletters at a steep discount: $1,749 off per year. Sign up for Casey OnePass here.

And finally, a bit of toilet humor…

Until next week…