Created in the late 1800's, convertibles combine the best attributes of both stocks and bonds in one investment vehicle. Convertible bonds and preferreds are fixed-income instruments that are exchangeable into a predetermined amount of an underlying common stock. This hybrid nature allows convertible investors to earn current income without foregoing the long-term call on equities that is normally associated with holding common stocks. As the underlying common stock rises, the equity feature allows the convertible's price to advance; as the underlying common stock falls, the fixed-income component helps to cushion a possible decline in the convertible price. The convertible's upside potential normally exceeds the downside potential, creating what is commonly referred to as "convertible leverage". This favorable leverage is a result of asymmetrical risk/return patterns that ultimately benefit the investor by enhancing portfolio performance.

Like any other bond, a convertible is a promise from the issuing company to pay back the principal plus an annual interest rate. The conversion feature gives the investor in the convertible the right (not the obligation) to convert or exchange the bond, at the investor's discretion, into a specified number of shares of the issuer's common stock. Coupon rates for convertibles tend to be slightly less than their "straight" bond cousins, but investors are willing to accept the lower yield to take advantage of the potential upside gain in the common stock. Until converted, called or redeemed, the convertible bond provides fixed current income, and the conversion feature permits the holder to participate in the potentially unlimited appreciation of the company's stock. Convertible preferred stocks share similar characteristics with convertible bonds except, unlike bonds, they often do not have a maturity date. They are senior in the capital structure to common equity, pay a fixed dividend rate, and participate with the common stock on the upside due to the conversion feature.
 

Like equities, convertible bonds provide investors with growth opportunities linked to the performance of the company's stock. The bond's value will increase and decrease with the stock's performance but at a varying ratio depending on where the convertible is valued at a given time. Convertibles trading in the “mid-market” (75% - 130% of par) have, over time, captured approximately 2/3's of the stock upside and only participated in approximately 1/3 of the stock's downside. In this “mid-market” area is where the convertible best performs - where the risk/reward opportunity is fully utilized.