What Is a Convertible Bond?

A convertible bond is a fixed-income debt security that pays interest payments but can be converted into a predetermined number of common stock or equity shares. The conversion from bond to stock can be done at certain times during the bond's life and is usually at the discretion of the bondholder.

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Convertible Bonds

Convertible Bonds Explained

Convertible bonds are a flexible financing option for companies. A convertible bond offers investors a type of hybrid security, which has features of a bond such as interest payments while also having the opportunity of owning the stock. A convertible bond has a conversion ratio, which determines how many shares of stock are converted from one bond. For example, a 5:1 ratio means that one bond would convert to five shares of common stock.

Key Takeaways

  • A convertible bond is a fixed-income debt security that pays interest payments but can be converted into a predetermined number of common stock or equity shares.
  • The conversion from bond to stock can be done at certain times during the bond's life and is usually at the discretion of the bondholder.
  • A convertible bond offers investors a type of hybrid security, which has features of a bond such as interest payments while also having the option of owning the stock.

Types of Convertible Bonds

A vanilla convertible bond provides the investor with the choice to hold the bond until maturity or convert it to stock. If the stock price has decreased since the bond's issue date, the investor can hold the bond until maturity and get paid the face value. If the stock price increases significantly, the investor can convert the bond to stock and either hold or sell the stock at their discretion. Ideally, an investor wants to convert the bond to stock when the gain from the stock sale exceeds the face value of the bond plus the total amount of remaining interest payments.

Mandatory convertible bonds are required to be converted by the investor at a particular conversion ratio and price level. On the other hand, a reversible convertible bond gives the company the right to convert the bond to equity shares or keep the bond as a fixed income investment until maturity. If the bond is converted, it is done so at a preset price and conversion ratio.

Benefits and Disadvantages of Convertible Bonds

Issuing convertible bonds can help companies minimize negative investor sentiment that would surround equity issuance. Each time a company issues additional shares or equity, it adds to the number of shares outstanding and dilutes existing investor ownership. The company might issue convertible bonds to avoid negative sentiment. Bondholders can, then, convert into equity shares should the company perform well.

Issuing convertible bonds can also help provide investors with some security in the event of default. A convertible bond protects investors' principal on the downside but allows them to participate in the upside should the underlying company succeed.

A startup company, for example, might have a project that requires a significant amount of capital resulting in a loss in the near-term revenues. However, the project should lead the company to profitability in the future. Convertible bond investors can get back some of their principal upon failure of the company while they can also benefit from capital appreciation, by converting the bonds into equity, if the company is successful.

Investors can enjoy the value-added component built into convertible bonds meaning they're essentially a bond with a stock option, particularly a call option. A call option is an agreement that gives the option buyer the right, but not the obligation, to buy a stock, bond, or other instrument at a specified price within a specific time period. However, convertible bonds tend to offer a lower coupon rate or rate of return in exchange for the value of the option to convert the bond into common stock.

Companies benefit since they can issue debt at lower interest rates than with traditional bond offerings. However, not all companies offer convertible bonds. Also, most convertible bonds are considered riskier or to exhibit more volatility than typical fixed-income instruments.

The Pros and Cons of Convertible Bonds

Pros

  • Investors receive the interest payments of a fixed-rate investment with the option to convert to stock to benefit from stock price appreciation

  • Can provide investors with some security in the event of default since bondholders are paid before common stockholders

  • Companies benefit by raising capital without immediately diluting their shares

  • Companies pay lower interest rates on their debt compared to traditional bonds

Cons

  • Offer a lower coupon rate in exchange for the value of the option to convert the bond into common stock

  • Can carry additional risk if the convertible bonds are issued by companies with little or no earnings such as start-ups

  • Share dilution can occur if the bonds are converted to stock, which could hurt investors if the result is a depressed stock price

Real World Example of a Convertible Bond

As an example, let's say Exxon Mobil Corp. (XOM) issued a convertible bond with a $1,000 face value that pays 4% interest. The bond has a maturity of 10 years and a convertible ratio of 100 shares for every convertible bond.

If the bond is held until maturity, the investor will be paid $1,000 in principal plus $40 in interest for that year. However, the company's shares suddenly spike and are trading at $11 per share. As a result, the 100 shares of stock are worth $1,100 (100 shares x $11 share price), which exceeds the value of the bond. The investor can convert the bond into stock and receive 100 shares, which could be sold in the market for $1,100 in total.