When Convertible Bonds Become Stock

A unique combination of debt and equity, convertible bonds provide investors with the chance to convert a debt instrument into shares of the issuer's common stock at a set price and usually by a set date. This conversion is usually done at the discretion of the bondholder, but in some cases, the trigger on convertible bonds is share price performance: As soon as the issuer's share price reaches a given threshold, the bonds convert automatically.

For this reason, convertible bonds are a bone of contention among some investor and shareholder advocates.

Issuing convertible bonds can be a flexible financing option for companies. They tend to be more useful for companies with high risk/reward profiles. They often issue convertibles to pay lower interest rates on their 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.

Companies who have weak credit ratings, but who expect their earnings and share prices to grow substantially within a certain time period, also tend to favor convertible bonds.

When a company exercises its right to redeem, or "call," a convertible bond – that is, force its conversion to shares of stock – it's called a forced conversion. If the issuing company outlines the conditions under which the change occurs – usually in the bond's prospectus – it's called a "forced conversion call feature." A company often forces a conversion when the price of the underlying security rises, or is threatening to rise, above the bond's conversion price (the point at which the bondholder had the option to cash it in or exchange it for shares). This means the bonds can be retired without requiring any cash payout on the issuer's part.

So why the controversy? Because the stocks that convertible bondholders get when they convert their bonds come in the form of newly issued securities. Therefore, in the absence of anti-dilution provisions, convertible bonds almost always dilute the ownership percentage of current shareholders.

The result is that stockholders own a smaller piece of the pie after bondholders convert their holdings. For example, Carnival Corp. (CCL) issued some zero-coupon convertible bonds back in 2003 that automatically converted to stock if Carnival's share price hit $33.77. According to the terms of the indenture, convertible bondholders would be allowed to buy the company's stock at $30.70 per share. Since the bonds didn't pay much interest, the $3.07 difference between the market price and the conversion price of the bonds provided bond investors a bit of a sweetener for buying them. Unfortunately for stockholders who didn't own the bonds, the bonds converted to over 17 million shares of stock, making for a highly dilutive conversion and adverse impact to their existing positions.

Then too, there's the fact that the bondholders may not have wanted the common stock at that time, but would have preferred getting an income stream from the coupons. Or perhaps they would have preferred to convert at an even higher price.

Forced conversions rarely end to the benefit of the holders of the convertible bond.

In addition, convertible bonds with the juiciest conversion features—low conversion prices, preferential conversion ratios, and above-market interest rates—are issued in private placements to investors who already have financing relationships with the company. Most small-time investors don't ever get the chance to buy them. Unfortunately for the common retail investor, this frustrating practice is unlikely to change in the near future.