What Are Convertible Bonds? Definition, Types, Pros and Cons

People in investing often look for options that promise security and potential for high- growth. Convertible bonds offer both. Read on to know how. 

Since a convertible bond has characteristics of both bonds and equity, it's a hybrid security asset. For investors seeking a balance between steady income and the chance for significant capital appreciation in their investment portfolio, convertible bonds offer a compelling option.

They are often issued by companies to institutional investors who provide portfolio management services to their clients using wealth management tools. Retail buyers can buy convertibles if they become available via their brokerage, often several months after issuance. Otherwise, a retail investor can add convertibles to their portfolio via mutual funds or exchange-traded funds (ETFs) that invest in convertible bonds.

Convertible bonds explained

Convertible bonds start as a way for a company to get debt capital in the short term. The company pays regular interest like any other bond. The investor gets the option to convert their investment from debt to stock anytime they want.

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 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.

If a convertible bond is not converted into stock, 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.

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

Conversion ratio of convertible bonds

The conversion ratio of a convertible bond is the number of shares of common stock that bondholders get when they convert their bond. It's usually expressed as a fixed number of shares per bond or as a ratio of shares to bonds. For example, a bond with a 10-to-1 conversion ratio can be converted into 10 shares of common stock.

The conversion ratio is calculated by dividing the face value (par value) of the bond by the conversion price of the share.

For example, if the face value of the above mentioned bond is $1,000 and the current share price or the conversion price is $20, then the conversion ratio is 1000 divided by 20 or 50. 

The conversion ratio is a key factor in considering the value and attractiveness of a convertible bond. A higher conversion ratio means investors get more common stock for each converted bond. Bonds with higher conversion ratios are more attractive to investors, especially if the stock price is rising. 

Types of convertible bonds

There are several types of convertible bonds, each with different features. Here are some most commonly issued convertibles.  

Vanilla convertible bonds

These are the most basic type of convertible bonds. They offer investors the option to convert their bonds into a predetermined number of shares of the issuing company's common stock at a specified conversion price.

Mandatory convertible bond

Also known as "mandatory converts" or "forced converts," these bonds automatically convert into shares of the issuing company's common stock at a predetermined date or when certain conditions are met. They typically offer a higher interest rate to compensate for the lack of choice.

Reverse convertible bonds

In contrast to traditional convertible bonds, where bondholders have the option to convert into equity, with reverse convertible bonds, the issuer holds the option to convert the bond into a predetermined amount of cash or equity at maturity. 

Why do companies issue convertible bonds? 

Following the pecking order theory for financing, companies first rely on their internal cash reserves. When those are depleted, they may then turn to debt financing. Convertible bonds offer an attractive option because they typically come with a lower coupon rate than traditional corporate bonds. This translates to lower interest payments for the company.

They are especially appealing for young companies and startups, who are in need of capital. Even if there's growing revenue and income, many startups have negative cash flows because their investments exceed their operating cash flows. Convertible gives them quick access to money via debt even if they have a low credit rating. 

The businesses can issue them before an IPO (initial public offering after which stocks in the company can be purchased). Once these young companies grow and go public (or their stock appreciates), investors can convert their bonds to stock while company debt disappears. It delays the dilution of stock to its equity holders.

Convertibles also provide a way to control the debt-to-equity ratio. When the stock price increases, convertibles can be issued, thus converting debt to equity and cleaning up the balance sheet. It's also issued to satisfy the need for additional capital.

Why do investors prefer convertible bonds?

Investors will make less money off convertible bonds’ coupon rate, but they have an opportunity to convert their bonds into stock once they appreciate, 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.

Pros and cons of convertible bonds

Convertible bonds come with their own set of advantages and disadvantages for both investors and companies. Following are the advantages of convertible bonds for investors. 

• Potential for capital appreciation: If the company's stock price rises above the conversion price, investors can convert their bonds into shares and capture those gains, similar to owning stock.
• Downside protection: Unlike common stock, convertible bonds come with a fixed maturity date and a fixed value that investors receive if they don't convert. This provides a level of security compared to owning just stock.
• Regular income: Convertible bonds offer regular interest payments like a traditional bond, providing a steady stream of income.

For companies, convertibles provide an option to raise capital without immediately diluting its ownership by stock issuance. However, it has several drawbacks too. 

• Lower interest rates: Compared to regular bonds of the same company, convertible bonds typically have a lower interest rate due to the potential for stock conversion.
• Conversion risk: If the company's stock price doesn't rise above the conversion price by maturity, investors won't capture any capital appreciation and are limited to the fixed interest payments which is extremely low.
• Dilution risk: If many bondholders convert their bonds to stock, it can increase the number of shares outstanding, potentially diluting the ownership stake and earnings per share of existing shareholders.

Despite the cons, convertible bonds remain an attractive financial instrument to diversify asset classes in an investor's portfolio. 

Example of convertible bonds

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 in the convertible bonds, allowing them to profit immediately by selling the shares.

Ready to convert? 

Convertible bonds are good investment options for both institutional investors and retail investors, who can buy them via ETFs or mutual funds. But before investing, one should do adequate research.  Consider risk tolerance, investment goals, and the specific terms of each convertible bond.  With a well-informed approach, convertible bonds can help convert one's investment strategy into a winning formula. 

Want to learn more? Explore financial predictive analytics software to drive investment strategy with historical data analysis.

This article was originally published in 2019. It has been updated with new information.