What is a convertible bond?

A convertible bond is a fixed-income corporate debt security that pays periodic interest and gives the bondholder the right to convert the bond into a predetermined number of the issuer’s common shares under specified terms. Convertible bonds can be used as a hedging tool because their structure provides downside protection compared to holding the stock outright.

Because it is a hybrid security it is sensitive to various factors, including price of underlying stock, the issue's credit rating and change in the interest rates.

The conversion ratio determines how many shares the bondholder receives upon conversion. The conversion price is calculated by dividing the bond’s par value by the conversion ratio. It represents the effective price at which shares are acquired through conversion. A convertible bond does not need to be converted. It can be held until the bond's maturity date.

Key takeaways

• Convertible bonds are hybrid instruments
  They are corporate debt securities that pay interest and can be converted into a fixed number of common shares.
• They offer income with potential equity upside
  Investors receive interest payments and may benefit if the issuer’s share price rises.
• They provide more downside protection
  Convertible bonds typically provide more downside protection than common stock because they rank as debt and pay coupons.
• Value depends on fixed conversion terms
  Conversion ratio, conversion price, and maturity are set at issuance and guide conversion decisions.
• They carry specific risks
  Convertible bonds are sensitive to stock prices, interest rates, issuer credit quality, and possible share dilution.

What is the difference between convertible bonds and traditional bonds?

Convertible bonds and regular bonds are quite similar but there are a few differences that are worth knowing.

First is capital appreciation. Convertible bonds offer potential capital appreciation through conversion into equity, whereas traditional bonds provide fixed income without equity participation.

Next, convertible bonds typically offer lower coupon rates than comparable straight bonds because the embedded equity option has value to investors.

As convertible securities, corporate bonds are traded on the secondary market, so investors can have the choice to buy or sell the bonds before maturity. This is also a feature of regular bonds. But the bond issuer's credit rating and outside market conditions can have a drastic effect on the liquidity of both convertible securities and regular bonds. Companies may issue both types of bonds as investor appetite for liquidity drives preference for one over another.

Convertible bonds can also be used as a quick way to rebalance a portfolio heavy in debt instruments. The flexibility to convert those convertible bonds instead of having to sell them is another attractive feature only present in convertible bonds.

Convertible bond features

Conversion option

Convertible bonds come with the conversion option so the bondholder can convert the bond into shares of the issuing entity's stock. The conversion option functions similarly to an equity call option, giving investors the right, but not the obligation, to convert into shares.

Interest payments

A convertible bond pays interest to bondholders. These interest payments will usually have a lower coupon rate and lower interest rate than non-convertible bonds to compensate for the conversion opportunity.

Maturity date

Both convertible and regular bonds have a fixed maturity date when the principal amount of the bond is due to be repaid by the issuer. If the convertible bonds are not optioned, they will mature on the maturity date and receive face value of the bond.

Conversion ratio

This conversion feature is the number of shares of shares a bondholder can expect to receive upon conversion. This number is fixed at the time the bond is issued and is expressed in number of shares per bond. For example, a 5:1 ratio will convert as five shares of company stock per one bond.

Conversion price

This is the price at which the bond is converted into shares of a particular company. It is usually set at a premium to current price of the stock.

Call and put options

Many convertible bonds include a call feature allowing the issuer to redeem the bond before maturity, often after a specified period. Some also include a put feature allowing bondholders to sell the bond back to the issuer at a predetermined price.

Varieties of convertible bonds

Vanilla convertible bonds are either held until maturity or are converted to the issuer's company stock. If the value of the stock has decreased since bond issuance, the investor can hold the vanilla convertible bond until it matures and receive its face value.

If the underlying stock' price goes up, investors can option to convert the bond to the more valuable stocks, at their discretion.

Mandatory convertible bonds automatically convert to stocks on a certain date included in the bond's indenture.

Calculating the conversion price of convertible bonds

The conversion price is typically set at a premium to the issuer’s current share price at issuance. This means conversion becomes attractive only if the stock price rises above that level.

The conversion price is the par value set by dividing the bond's face value by the conversion ratio.

For example, if a convertible bond has a face value of $2,000 and a ratio of 20:1. $2,000 divided by 20 shares equates to a $100 stock price.

The conversion ratio is generally fixed at issuance but may be adjusted for events such as stock splits, dividends, or other corporate actions.

Advantages and disadvantages of convertible bonds

The advantages of holding convertible bonds should also be considered.

Because of the conversion option, they offer lower coupon rates. Convertible bond investors face additional credit risk when dealing with companies with minimal or high growth potential and no earnings. If the bonds are converted into stocks, share dilution might happen, potentially leading to a decrease in the share price.

There are also some disadvantages to holding convertible bonds. Issuing companies with little or no earnings create additional risk for convertible bond investors. Convertible bond investors face additional credit risk when dealing with companies with minimal earnings or lower bond ratings, which may indicate a higher risk of default.

Issuing convertible bonds can also help keep investors more positive around an equity distribution. When a company issues new additional shares, it adds to the outstanding common shares, diluting the ownership of current investors.

Issuing convertible bonds is a strategy to help avoid negative investor sentiments. Once done, bondholders can take advantage of raising equity should the company do well. Investors should also consider that some convertible issuers fall into the highyield bond category, meaning they carry higher credit risk despite offering equity linked upside.

When can bondholders convert their bonds?

Bondholders can exercise their option to convert their bonds into issuing company stock at any time during the life of the bond before it reaches maturity, as long as all terms of the bond have been met. Some companies may stipulate that the bond/stock conversion can only happen after being held for a specified time.

What is a forced conversion?

A forced conversion typically occurs when the issuer exercises a call option after the stock trades above a specified threshold, prompting bondholders to convert rather than accept redemption.

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FAQs

What risks are unique to convertible bonds compared to equity and straight debt?

 Convertible bonds can come with higher credit risk, especially if the issuer has weak earnings. If converted, they can also dilute existing shares, which may weigh on the stock price.

How do forced conversions affect total return calculations?

 With a forced conversion, the issuer requires bondholders to switch into stock.

This can alter total return because future coupon payments cease and returns become fully dependent on the stock price at conversion.

Why are coupons lower on convertibles, and how should I compare returns?

Coupons are lower because the ability to convert into stock is already valuable. When comparing returns, look at the whole package, interest income plus potential equity upside and some downside protection.

What’s the impact of rate moves and credit on a convertible’s pricing?

 Convertible prices react to multiple factors. Higher rates or weaker credit push prices down, while stronger stock performance or better credit can lift them.

How do businesses decide between holding to maturity vs. converting?

 It usually comes down to comparing the current stock price with the conversion price and deciding whether equity upside outweighs the value of continuing to earn interest.

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This material is for informational purposes only and should not be considered as an investment recommendation or a personal recommendation.