Convertible bonds – What are they, definition & examples

A convertible bond is a fixed-income corporate debt security that yields investment dividends but may be converted into stock of a predetermined number at various points in the life cycle of the bond, at the bondholder's discretion.

Convertible bonds are hybrid securities that allow holders to convert the bonds into a predetermined number of shares of the issuer's common stock. 

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.

A bond's conversion ratio is the number of common stocks the bondholder receives for converting the bond.

A bond's conversion price is the price per share at which a bond can be converted to common stock. Once a conversion ratio has been established, underlying share price is set.

A convertible bond does not need to be converted. It can be held until the bond's maturity date.

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, which is equity the bondholder builds if the company's stock share price ever increases. Regular bonds do not offer the investor this equity opportunity, as they act simply as debt instruments.

Next, the interest rates paid on convertible bonds are often lower than those of interest payments on regular bonds because convertible bonds offer potential conversion equity. Higher interest rates are paid to offset negative investor sentiment and compensate investors for this lack of equity opportunity.

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 of one over another.

Convertible bonds can also be uses 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 features 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 share of the issuing entities stock.

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 preferred stock a bondholder can expect to receive upon conversion. This number is fixed at the time the bone 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

A call option allows the issuer to force conversion or redeem the bond before maturity, often at a premium price. This extra bit of flexibility allows the bondholder to sell the bond back to the issuer at a specific price before maturity, allowing exit and raising capital and liquidity if needed.

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

Conversion price is typically set at a premium to provide an incentive to convert the bonds to equity, assuring they acquire shares for a lower price than if they were purchased on the open market.

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.

When a convertible bond is issued the ratio established and remains fixed throughout the life of the bond. This ratio does not change regardless of share price.

In some instances, when the bond is created, the conversation rate may be set to be unfavorable to convert to stock. At or below market price of the underlying common stock shares which would allow for quick turn-around at a profit for bondholders, negating the use of the debt instrument. In this case, an investor might prefer to hold the equity instead of the debt.

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's price,

There are also some disadvantages to holding convertible bonds. Issuing companies with little or no earnings create additional risk for convertible bond investors.

Issuing convertible bonds tend to can also help keep investors more positive around an equity distribution. When a company 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.

How Does a Convertible Bond Work?

A convertible bond is a fixed-income security that can be converted from a bond into shares of an issuing company. At the bondholder’s discretion they may convert the single bond into a set number of company shares at a set conversion price. Should they decide to not exercise that option to convert, they will continue to get interest payments until the maturity date of the bond, when they will surrender the bond and receive the principal amount.

What Is the Conversion Ratio?

The number of shares that a bondholder will receive on conversion is called the conversion ratio and is written as 5:1, meaning a single bond is equal to five share of company common stock.

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?

The issuer of the bonds retains the option to call the bonds and forcibly convert them into common stocks at their discretion. When the stock price exceeds the bond's redemption or maturity price, the issuer may decide to carry out a forced conversion.

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