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.

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

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 sub-par return (below what a non-convertible corporate bond would get). As always, there is a tradeoff between risk and return. (For more insight, read Get Acquainted With The Bond Price-Yield Duo.)

Companies issue convertible bonds or debentures for two main reasons:

• 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. 
• To delay dilution: Raising capital through issuing convertible bonds rather than through 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 have grown 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). 

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.

• 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 could be specified at a 50% premium, meaning that if the investor chooses to convert the shares, he or she will have to pay the price of the common stock at the time of issuance, plus 50%. (Basically, these are the same thing, but said two different ways.)

This chart shows the performance of a convertible bond as the stock price rises. Notice that 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, bond holders would receive no less than the par value.

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, or this may 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. (To learn more about callable bonds, read Bond Call Features: Don't Get Caught Off Guard.)

For example, Twitter, Inc. (TWTR) issued a convertible bond, raising $1.8 billion in September 2014. The notes were in two tranches, a five-year due in 2019 with a 0.25% interest rate, and a seven-year due in 2021 at 1%. The conversion rate is 12.8793 shares per $1,000, which at the time was about $77.64 per share. The price of the stock has ranged between $35 and $56 over the last year.

To make a profit on the conversion, one would have to see the stock more than double from the $35–$40 range where it has spent the last two months. The stock certainly could double in short order, but clearly it's a volatile ride. And given a low-interest rate environment, the principal protection isn't worth as much as it might otherwise be. (For related reading, see: How Does Twitter Make Money?)

As we mentioned earlier, 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 the price of these securities; 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 share price. All of these factors are important when pricing convertibles.

• Example: Suppose that TSJ Sports issues $10 million in three-year convertible bonds with a 5% yield and a 25% premium. This means that TSJ will have to pay $500,000 in interest annually, or a total $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 x 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 that while convertible bonds limit risk if the stock price plummets, they also limit exposure to upside price movement if the common stock soars.

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 they're unsure of, and by investing in convertibles, you are limiting your downside risk at the expense of limiting your upside potential.