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

If you’ve ever felt stuck choosing between the safety of bonds and the growth potential of stocks, convertible bonds might be exactly what you’re looking for.

Think of them as a “best of both worlds” investment: you get the steady income of a bond, but with the option to convert into company stock if things take off.

These hybrid securities are often issued by companies to institutional investors who provide portfolio management services to their clients using wealth management tools.

Convertibles are also accessible to retail investors through brokerages (though usually after the initial offering) or via mutual funds and ETFs dedicated to convertible strategies. In this article, I’ll break down what convertible bonds are, how they work, and why they’re worth considering.

How do convertible bonds work?

Convertible bonds begin as debt: the company raises capital and pays regular interest like a traditional bond. What makes them different is the built-in option for investors to exchange the bond for shares of the issuing company.

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 converted, the company reduces its debt and issues equity instead. If not, the investor continues receiving interest until maturity, when the principal is repaid. This flexibility is what makes convertibles appealing.

This ability to switch from debt to equity doesn’t happen randomly. It’s governed by specific terms set when the bond is issued. The most important of these is the conversion ratio and conversion price.

What is a conversion ratio?

The conversion ratio tells investors how many shares of stock they receive when they convert a bond. It is calculated by dividing the bond’s par value by the conversion price. 

For example, if a bond has a par value of $1,000 and a conversion price of $20, the ratio is 50. That means each bond can be exchanged for 50 shares. 

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

What is the conversion price?

The conversion price is the predetermined price at which a bondholder can convert their bond into shares of stock. It’s essentially the “deal price” set when the bond is issued, and it stays fixed regardless of how the market stock price moves.

For example, if a bond has a par value of $1,000 and a conversion ratio of 50, the conversion price is $20 ($1,000 ÷ 50).

If the company’s stock price rises above the conversion price, the investor stands to gain by converting, since they’re effectively buying stock at a discount. On the other hand, if the stock trades below the conversion price, investors may choose to hold the bond instead, collecting interest until maturity.

How convertible bond prices move with stock prices

The value of a convertible bond depends not only on interest rates and credit quality but also on the performance of the underlying stock. Here’s how price behavior typically works:

If the share price falls

The convertible bond’s sensitivity to the stock decreases. While equity may drop sharply, the bond will not fall as much because of the “bond floor” — the par value that the issuer has promised to repay at maturity. This floor provides downside protection.

If the share price rises

The fair value of the convertible bond increases. As the stock approaches the conversion price, the bond’s price becomes more correlated with the equity. Once the stock trades above the conversion price, the bond price begins to closely track the share price, reflecting its equity-like upside.

What is a practical example of a convertible bond in action?

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% 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.

What is the difference between regular bonds and convertible bonds?

While convertible bonds share many similarities with regular bonds, there are some key differences that set them apart:

What are the types of convertible bonds?

Now that we’ve covered how convertible bonds compare to traditional bonds, it’s worth noting that not all convertibles are created equal. Companies can issue them in different forms, each with its own features, risks, and benefits. Let’s look at the main types of convertible bonds you might encounter as an investor. 

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? 

Companies often follow the “pecking order theory” of financing, using internal cash first, then debt, and finally equity. Convertible bonds fit neatly into this order by offering lower borrowing costs than regular bonds while postponing equity dilution. Some of the most common reasons why companies turn to convertible bonds include:

• Lower interest cost: Convertibles typically have a lower coupon rate than traditional bonds. The equity conversion feature compensates investors, allowing companies to raise capital at a reduced borrowing cost.
• Flexible financing: Convertibles provide short-term debt capital that can later be converted into equity, giving companies breathing room to manage cash flow, growth, or expansion without immediately issuing stock.
• Attractive for startups and growth companies: Young businesses often have negative cash flows or lower credit ratings, which makes traditional borrowing expensive. Convertibles offer them access to capital even before profitability or an IPO.
• Delay stock dilution: Instead of issuing equity right away, companies can raise capital through convertibles and only face dilution if bondholders choose to convert later. This protects early shareholders in the short term.
• Balance sheet management: When converted, these bonds reduce debt and increase equity, improving the company’s debt-to-equity ratio. Issuing convertibles can therefore “clean up” the balance sheet and strengthen financial stability.
• Additional capital flexibility: Convertibles can be issued to meet capital needs without immediately overburdening the company with high debt service costs or shareholder dilution.

Why do investors prefer convertible bonds?

Convertible bonds appeal to investors because they offer a blend of safety and growth potential. While coupon payments are usually lower than those of traditional bonds, the chance to convert into equity makes them an attractive addition to many portfolios. Key benefits include:

• Regular income: Investors still receive coupon payments (though typically lower than regular bonds), which provide steady cash flow while holding the bond.
• Equity participation: If the issuing company’s stock price rises, investors can convert their bonds into shares and capture upside gains — essentially buying stock at a discount.
• Downside protection: If the stock underperforms, investors can hold the bond until maturity and still receive their principal back, along with interest payments, reducing risk compared to owning equity alone.
• Diversification: Convertibles add variety to a portfolio by blending features of fixed income and equity. This makes them especially useful in balancing risk and reward across different asset classes.

What are the pros and cons of convertible bonds?

We’ve looked at why companies issue convertible bonds and why investors buy them. To round out the picture, here’s a side-by-side view of the main advantages and drawbacks for both parties:

What are the tax implications of convertible bonds?

Understanding the benefits and risks of convertible bonds is only part of the equation. For investors, it’s equally important to consider the tax treatment, since interest payments, conversions, and dividends can all have different implications for returns.

The tax treatment of convertible bonds depends on whether they are held as debt or converted into equity. Under U.S. tax law, the key considerations are:

• Interest income is taxable: While held as a bond, coupon payments are treated as ordinary income and taxed at the investor’s marginal tax rate.
• No tax at the moment of conversion: In most cases, the act of converting a bond into stock itself is not a taxable event. Taxes are triggered only when the stock is eventually sold.
• Capital gains tax on conversion: If the bond is converted into stock and later sold at a profit, the gain is generally subject to capital gains tax. The rate depends on whether the shares were held short-term (taxed at ordinary income rates) or long-term (taxed at capital gains rates)
• Dividends on converted shares: If a bondholder converts into stock and the company pays dividends, those dividends may qualify for preferential tax treatment as qualified dividends. For eligible investors, qualified dividends are taxed at lower rates than ordinary income.
• Redemption or maturity: If the bond matures without conversion, the return of principal is not taxed, but coupon interest earned along the way remains taxable as ordinary income.
• Special cases: Tax rules can differ if convertibles are held inside tax-advantaged accounts (like IRAs or 401(k)s), where interest and gains may be tax-deferred or tax-free.

Frequently asked questions about convertible bonds

Are convertible bonds debt or equity?

Convertible bonds start as debt — the issuing company borrows money and pays interest, just like with a regular bond. If the investor chooses to convert, they become equity by exchanging the bond for shares of stock.

Do convertible bonds pay interest?

Yes. Until conversion, convertible bonds pay coupon interest like traditional bonds. However, the coupon rate is usually lower than standard bonds because the conversion feature adds value for investors.

Who buys convertible bonds?

Both institutional investors (such as portfolio managers, hedge funds, and insurance companies) and retail investors can buy convertible bonds. Retail investors typically access them through brokerage offerings, mutual funds, or ETFs specializing in convertibles.

Who benefits from convertible bonds?

Investors benefit from a mix of fixed income, downside protection, and the chance to participate in stock appreciation.
Companies benefit by raising capital at a lower interest cost and delaying dilution compared to issuing stock outright.

What is the main reason for issuing a convertible bond?

Companies issue convertibles to raise money more cheaply than with regular bonds. The lower coupon reduces borrowing costs, while the equity conversion feature allows them to defer dilution until investors choose to convert.

What are the downsides of convertible bonds?

For investors: lower coupon rates than standard bonds, conversion risk if stock prices don’t rise, and potential liquidity concerns.
For companies: dilution risk when conversions happen, and potential downward pressure on share price.

Are convertible bonds risk free?

No. While they are less risky than stocks because of their bond floor, convertible bonds still carry risks such as company default, lower interest income, and the possibility that conversion never becomes profitable.

What happens to bonds if a company fails?

If the issuing company goes bankrupt, convertible bondholders are treated like other bondholders — they rank higher than shareholders in repayment priority but below secured creditors. Recovery depends on the company’s remaining assets.

Are convertible bonds a good investment now?

It depends on market conditions and the individual bond terms. In general, convertible bonds are most attractive when:

• Interest rates are low (making their lower coupons less of a drawback)
• The issuing company’s stock has strong growth potential

Investors should weigh their own risk tolerance and market outlook before investing.

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.