Depending on where they live, convertible owners keep the tops of their cars covered for most of the colder months.

When the conditions are right, the retractable top comes down and a cruise down the highway becomes a completely different experience.

The same thing happens when convertible bondholders decide to convert their bonds into stock, but instead of waiting for a warm, sunny day, they must wait for good conditions in the stock market.

What are convertible bonds?

Convertible bonds are a type of corporate bond, but they differ in that investors have the option to convert them into stock.

As a hybrid security (a financial asset that has characteristics of both bonds and stock), convertible bonds start as a way for a company to generate debt capital in the short term. In the long term, convertible bonds may fit into a company’s capital structure as either debt financing or shareholder equity, depending on the bondholder’s action.

If a convertible bond is not converted, it earns fixed interest payments on a set schedule until its maturity date. At this date, the principal amount, or the amount originally borrowed from the investor, is paid back by the company — just like a regular bond.

However, if the investor decides to convert the bond into stock, they get a previously-agreed upon number of shares in return for their bond, and the company converts some of its debt into shareholder equity.

While that might seem complicated, both companies and investors benefit from the flexibility that comes with convertible bonds.

Convertible bonds for companies and investors

In addition to their flexibility, there are other incentives for issuing and purchasing convertible bonds, and some things both companies and investors should be wary of before jumping into this kind of financing.

For companies

Companies are able to get away with paying a lower coupon rate (periodic payment rate) on convertible bonds, meaning that the interest payments are lower than that of most corporate bonds. However, since the bondholders may convert their bonds into shares (company equity), the value of the company’s shares may go down due to dilution — the more stocks they have outstanding, the less each stock is worth.

Convertible bonds are especially appealing for young companies and startups, who can issue them even before an IPO (initial public offering after which stocks in the company can be purchased), giving them quick debt capital. Once these young companies grow and go public (or their stock appreciates), investors can convert and the company debt disappears.

For investors

Investors will make less money off convertible bonds’ coupon rate, but they have an opportunity to convert their bonds into stock once it appreciates, often earning more in the long run.

Remember that each convertible bond has an agreed-upon amount of shares it can be converted into. Smart investors will wait until the price of company stock rises to the point in which those shares are worth more than the principal value, or initial price paid for the bond, then convert and cash in.

Example of a convertible bond

Let's say a car company issues convertible bonds at $1000 each with a coupon rate of 2%. Each bond can be converted into 10 shares in the company (which, as of the bond issuance date, are worth $50 each).

If held like a regular bond, investors would earn $20 (2 percent of $1000) each year until the bond’s maturity date, at which investors would be paid back the $1000 principal amount.

At this point, investors would not benefit from converting their bonds into shares, as the $1000 they put down towards the bond investment would convert into 10 shares valued at $50 each. That’s only half of the value (a $500 value) of the principal amount of the bond ($1000).

Several years later, the company stock has appreciated and is now worth $150 per share. This would be a good time for convertible bondholders to convert their bonds and cash in on the stock market.

The 10 shares, now valued at $1,500 ($150 x 10) would be given to investors in exchange for each bond. The shares are now worth more than the principal amount they invested on the convertible bonds, allowing them to profit immediately by selling the shares.

Don’t use cruise control

Convertible bonds are not the kind of asset you can invest in, sit back, and watch earn interest. Companies and bondholders must keep a finger on the pulse of the stock market and company finances in order to be successful investors, and investment portfolio management software can help them stay in the right lane.