An Introduction to Convertible Bonds

New players in the investing game often ask what convertible bonds are, and whether they are bonds or stocks. The answer is that they can be both, but not at the same time.

Essentially, convertible bonds are corporate bonds that can be converted by the holder into the common stock of the issuing company. Below, we’ll cover the basics of these chameleon-like securities as well as their upsides and downsides.

Key Takeaways

• Convertible bonds are corporate bonds that can be exchanged for common stock in the issuing company.
• Companies issue convertible bonds to lower the coupon rate on debt and to delay dilution.
• A bond’s conversion ratio determines how many shares an investor will get for it.
• Companies can force conversion of the bonds if the stock price is higher than if the bond were to be redeemed.

What Is a Convertible Bond?

As the name implies, a convertible bond gives the holder the option to convert or exchange it for a predetermined number of shares in the issuing company. When issued, they act just like regular corporate bonds, albeit with a slightly lower interest rate.

However, some companies issue convertible bonds that convert to a predetermined market value rather than a set number of shares. Known as death spiral debts, these bonds can effectively drive the market share price down as they are converted.

Because convertibles can be changed into stock and, thus, benefit from a rise in the price of the underlying stock, companies offer lower yields on convertibles. If the stock performs poorly, there is no conversion, and an investor is stuck with the bond’s subpar return—below what a nonconvertible corporate bond would get. As always, there is a tradeoff between risk and return.

How to Buy Convertible Bonds

Investors can buy convertible bonds through their financial advisor, investment advisor, or brokerage accounts. However, brokerages often don’t offer them because they tend to be more complicated than other types of bonds. Another way to purchase convertible bonds that is a more convenient workaround is to invest in exchange-traded funds (ETFs), index funds, mutual funds, or closed-end funds that hold these bonds.

Why Do Companies Issue Convertible Bonds?

Companies issue convertible bonds or debentures for two main reasons. The first is to lower the coupon rate on debt. Investors will generally accept a lower coupon rate on a convertible bond, compared with the coupon rate on an otherwise identical regular bond, because of its conversion feature. This enables the issuer to save on interest expenses, which can be substantial in the case of a large bond issue.

Note

A vanilla convertible bond allows the investor to hold it until maturity or convert it to stock.

The second reason is to delay dilution. Raising capital through issuing convertible bonds rather than equity allows the issuer to delay dilution to its equity holders.

A company may be in a situation wherein it prefers to issue a debt security in the medium term—partly since interest expense is tax deductible—but is comfortable with dilution over the longer term because it expects its net income and share price to grow substantially over this time frame. In this case, it can force conversion at the higher share price, assuming the stock has indeed risen past that level.

Conversion Ratio of Convertible Bonds

The conversion ratio—also called the conversion premium—determines how many shares can be converted from each bond. This can be expressed as a ratio or as the conversion price and is specified in the indenture along with other provisions.

For example, a conversion ratio of 45:1 means one bond—with a $1,000 par value—can be exchanged for 45 shares of stock. Or it may be specified at a 50% premium, meaning if the investor chooses to convert the shares, they will have to pay the price of the common stock at the time of issuance plus 50%.

The chart below shows the performance of a convertible bond as the stock price rises. Notice the price of the bond begins to rise as the stock price approaches the conversion price. At this point, your convertible performs similarly to a stock option. As the stock price moves up or becomes extremely volatile, so does your bond.

It is important to remember that convertible bonds closely follow the underlying share price. The exception occurs when the share price goes down substantially. In this case, at the time of the bond’s maturity, bondholders would receive no less than the par value.

The Downside of Convertible Bonds: Forced Conversion

One downside of convertible bonds is that the issuing company has the right to call the bonds. In other words, the company has the right to forcibly convert them. Forced conversion usually occurs when the price of the stock is higher than the amount it would be if the bond were redeemed. Alternatively, it may also occur at the bond’s call date.

This attribute caps the capital appreciation potential of a convertible bond. The sky is not the limit with convertibles as it is with common stock.

The Numbers on Convertible Bonds

Convertible bonds are rather complex securities for a few reasons. First, they have the characteristics of both bonds and stocks, confusing investors right off the bat. Then you have to weigh in the factors affecting their price.

These factors are a mixture of what is happening in the interest rate climate, which affects bond pricing, and the market for the underlying stock, which affects the price of the stock.

Then there’s the fact that these bonds can be called by the issuer at a certain price that insulates the issuer from any dramatic spike in the share price. All of these factors are important when pricing convertibles.

Example

For example, suppose that TSJ Sports issues $10 million in three-year convertible bonds with a 5% yield and a 25% premium. This means TSJ will have to pay $500,000 in interest annually, or a total of $1.5 million over the life of the converts.

If TSJ’s stock was trading at $40 at the time of the convertible bonds issue, investors would have the option of converting those bonds for shares at a price of $50 ($40 × 1.25 = $50).

So, if the stock was trading at $55 by the bond’s expiration date, that $5 difference per share is profit for the investor. However, there is usually a cap on the amount the stock can appreciate through the issuer’s callable provision. For instance, TSJ executives won’t allow the share price to surge to $100 without calling their bonds and capping investors’ profits.

Alternatively, if the stock price tanks to $25, the convert holders would still be paid the face value of the $1,000 bond at maturity. This means while convertible bonds limit the risk if the stock price plummets, they also limit exposure to upside price movement if the common stock soars.

Why Would an Investor Want a Convertible Bond?

Convertible bonds are attractive to investors because they provide a fixed interest payment like traditional bonds but with the potential upside through capital appreciation of the shares. Investors would purchase convertible bonds of companies they believe will grow in the future. The investor would receive fixed interest payments and if the stock price hits the conversion level, the investor can obtain equity shares in the company. Ideally, the shares would further increase in price.

What Happens to Convertible Bonds If Interest Rates Go Up?

Interest rates and convertible bonds have the same relationship as interest rates and traditional bonds: an inverse relationship. When rates go up, the value of bonds goes down as the higher rate on new bond issues is more attractive to investors. To compensate for the lower yields on existing bonds, the price needs to come down. The opposite is true if interest rates go down. Additionally, rising interest rates tend to put downward pressure on stocks, which could further reduce the value of convertible bonds as there is less likelihood of an equity conversion.

What Is the Main Reason for Issuing a Convertible Bond?

Companies issue convertible bonds to raise capital to fund various needs, such as business operations and expansion. The potential for equity through the conversion can attract a wider range of investors as the bond is more appealing. Additionally, convertible bonds pay lower rates than traditional corporate bonds due to the potential upside through equity appreciation, making it a lower cost of borrowing for the issuer. Lastly, convertible bonds delay equity dilution until the conversion, allowing companies to maintain more control for a longer period of time.

The Bottom Line

Getting caught up in all the details and intricacies of convertible bonds can make them appear more complex than they really are. At their most basic, convertibles provide a sort of security blanket for investors wishing to participate in the growth of a particular company that they’re unsure of, and by investing in convertibles, you are limiting your downside risk at the expense of limiting your upside potential.