Newbie investors usually ask what convertible bonds are, trying to determine whether they are actually stocks or bonds. The answer can be confusing, as these assets can be both those two things, although not at the same time.
In a nutshell, convertible bonds are corporate bonds that you can convert into the common stock of the issuing company.
What is a Convertible Bond
A convertible bond offers you the choice to convert or exchange the asset for a predetermined number of shares in the issuing company.
When they are issued, they serve just like a regular bond. Usually, they have a slightly lower interest rate.
Since convertible bonds can be exchanged into a stock and therefore benefit from an increase in the price of the shares, companies usually offer lower yields with the convertibles.
If the stock isn’t exactly performing outstandingly, no conversion will happen and the investor will stay with the bond’s subpar return. Of course, that’s the tradeoff between risk and return.
Why Companies Issue Convertible Bonds
Companies issue convertible bonds or debentures because of two reasons.
The first is that they want to lower the coupon rate of the debt. Oftentimes, investors will accept lower coupon rate on a convertible bond because of the conversion feature.
The issuer will be able to save of interest expenses, which can be huge in the case of a large bond issue.
The second reason is that the company many want to delay dilution. When they raise capital through convertible bond issues instead of equity, investors let the issuer delay dilution to its equity holders.
A company may be in a situation where it wants to issue a debt security in the medium-term partly because the expense is tax deductible but also comfortable with dilution in the longer term if it expects its net income and stock price to grow significantly over this time.
In such a case, the company can force conversion at the higher share price, if the stock actually rose past that level.
The conversion premium, or conversion ratio, determines how many shares can be converted from each bond. One can express this as a ratio or as the conversion price and is specified in the indenture along with other provisions.
You also have to remember that convertible bonds closely track the underlying share price. The exception happens when the share price goes down substantially.
In such a case, the investors of the bond will receive at least par value at the time of the bond’s maturity.
One of the disadvantages of convertible bonds is that the company has the right to call the bonds, which means it can easily force convert them.
Forced conversion typically happens when the price of the stock is higher than the amount the company would pay if the bonds were redeemed. It may also take place at the bond’s call date.
Convertible bonds are also complex in that, apart from having the characteristics of both bonds and stocks, they confuse investors with the factors affecting the asset’s price.
Among these factors are the interest rate climate that influences bond pricing and that underlying stock’s market.