Convertible Bonds

What Is A Convertible Bond?

Convertible bonds are a hybrid security that act mainly as a bond but also give the holder the right to convert the security into common shares of the issuing company at certain times and usually at the investor's option. Unlike traditional corporate bonds, convertibles offer investors a limited opportunity to participate if the stock of the issuing company rises. If the company's stock falters, investors in convertibles are protected by their interest payments plus get their principal back when the bond matures.

Issuers Of Convertible Bonds

Convertibles are usually issued by companies with weak credit or startup companies that have yet to establish a strong credit rating. Investors in convertibles are willing to accept lower interest rates than on traditional corporate bonds because they offer the chance to profit if the stock price rises. If the stock price falls or doesn't appreciate, they still have the option of holding their bonds until maturity, getting their money back while collecting interest payments in the meantime.

However, in the event the company fails and is unable to repay its debts, holders of traditional bonds would be paid before convertible holders. However, convertible holders would be paid before equity holders.

Conversion Ratio

Convertible bonds are issued with a fixed interest rate and priced with a conversion ratio, meaning the number of shares investors would get if they converted one US$1,000 bond. For example, if the bond had a conversion ratio of 20, they would get 20 shares of stock, implying a common stock price of US$50.

If the stock was trading at US$40, it would make little sense for the investor to convert, so they would simply hold onto their bonds and collect the interest payments. If the stock increased to US$60, however, the investor might consider forgoing the interest and convert into equity, earning a US$10 per share profit.

The optimal point at which to convert is when the gain from conversion is greater than the face value of the bond plus the total amount of any remaining interest payments.

Callability

Another consideration is that most convertible bonds are callable, meaning the company can redeem the bonds at a certain price, effectively limiting the investor's gain. By the same token, however, convertibles pay interest and investors get their money back when the bonds mature— assuming the company hasn't failed—so the investor's downside is protected to some degree.

As a result, convertible bonds don't offer the same unlimited price potential that stocks do, while they offer some possible upside compared to traditional bonds. But they also provide some loss protection, which common stocks don't.

How Are Prices Tracked?

Generally, the price of convertibles tracks the underlying stock price, not the general trend of interest rates, as traditional bonds do. Investors can buy individual convertible bonds from their broker or through mutual funds or exchange-traded funds, which would reduce the overall risk by investing in a diversified pool of convertibles.

Convertible Varieties

Convertibles come in three main varieties.

1. Plain vanilla convertibles act as those described above, with the investor having the option to convert their bonds into equity at a specified price at designated times.
2. Mandatory convertibles require the investor to convert into equity at a specified price and conversion ratio.
3. Reverse convertibles give the issuer the option to buy back the bond in cash or convert the bond to equity at a predetermined price and rate at the maturity date.

Advantages of Convertible Bonds

Convertibles enable startups and companies with weak credit ratings to issue debt at lower interest rates than on traditional bonds. They also allow companies to raise money without diluting the value of their current shares, pushing that event into the future, presumably when the price of the stock is higher. Additionally, interest payments are tax-deductible in the U.S., so issuing convertible bonds is often a cheaper way for companies to raise money than issuing stock.

For investors, convertibles enable them to participate in the upside of the company's stock while being protected by interest payments. They also have the knowledge that they can get their principal back if the stock price doesn't rise beyond the conversion rate.

Disadvantages Of Convertible Bonds

Convertibles are generally more risky than traditional nonconvertible bonds, and they pay lower interest rates. Because they're usually issued by startups and other higher-risk companies, they have a greater likelihood of default. Traditional bondholders get paid back first before convertible holders in a bankruptcy.

Summary

A convertible bond is a security that acts as a bond but can be converted by the holder into common stock of the issuing company. Convertibles generally offer lower interest rates than on traditional bonds because of the exchange feature, which allows investors the opportunity to participate in the potential upside of the stock while being protected by the interest payments. Convertibles are generally more risky than traditional bonds because they are usually issued by startups and companies with weak credit ratings.