What are Convertible Bonds?

Stocks and bonds are two of the most popular investments. Stocks cater to investors who want to pursue higher potential returns, while bonds appeal to investors who want stable income and less risk. Some investors pick one or the other, but you can also get a little bit of both. Convertible bonds are a hybrid that gives investors exposure to stocks and bonds within the same asset.

How Do Convertible Bonds Work?

Convertible bonds pay out cash distributions just like regular bonds. These debt securities tend to have lower interest rates than traditional bonds, but you can convert your bond into common stock. Each convertible bond gives the bondholder a few opportunities to swap their bond for shares.

Investors don’t only have to look at the company’s financial health. They must also monitor the stock price and valuation. A company’s ability to gain market share and reward stockholders can make the convertible bond more attractive. 

You do not have to make the conversion, and it is possible to receive the principal without shares at maturity. This approach can be a good option if the stock has performed poorly or has several headwinds.

Types of Convertible Bonds

Investors can get exposure to several types of convertible bonds. These are some of your options:

• Mandatory Convertible Bonds: These bonds must get converted into stock at a predetermined date.
• Contingent Convertible Bonds: Financial institutions offer these bonds. They automatically convert into stocks once certain conditions get met.
• Exchangeable Bonds: Bondholders can convert their bonds into shares of a subsidiary or an affiliated company.
• Vanilla Convertible Bonds: Bondholders have the choice but not the obligation to convert bonds into common stock.
• Reverse Convertible Bonds: The bondholder has a bond plus a short put option on an underlying asset. The underlying asset is usually the issuing company’s stock.  

Examples of Convertible Bonds in Practice

Assume a convertible bond investor buys a bond with a value of $1,000. This bond has a conversion price of $20, meaning you can use the principal to buy common stock at $20 per share. If you decide to convert your bond into shares, you will receive 50 shares. That’s because buying 50 shares at $20 per share adds up to $1,000, the bond’s value. 

The conversion price still holds regardless of the market price. If common stock goes up to $30 per share by the time you convert your shares, you receive a $10 per share profit, totaling $500 in this example. However, if the common stock drops to $15 per share, you would lose $5 per share from converting the bond, resulting in a $250 net loss.

Benefits of Investing in Convertible Bonds

Investing in convertible bonds presents several advantages for investors. These are some of the highlights:

• Interest payments: You can receive consistent interest payments based on a designated schedule before converting your bond.
• The ability to buy shares: You can use the bond’s principal to buy common stock at a specified price per share. This price stays the same even if the stock performs well, potentially allowing you to buy shares at a discount. 
• Flexibility: You don’t have to commit to a bond conversion if the common stock performs poorly. You can instead wait for the bond to mature and continue to collect interest payments. Some convertible bonds have mandatory conversions.

Risks Associated with Convertible Bonds

While convertible bonds have many advantages, these assets are not perfect. Here are some of the risks to keep in mind before committing to a convertible bond.

• Not all convertible bonds convert: Convertible bonds must meet certain stipulations to enable conversions. If the conditions are not met, the bond may not convert.
• Potential common stock losses: Mandatory convertible bonds commit you to an asset’s performance. If the stock loses significant value while you hold on to the bond, you can lose money on your investment.
• Interest rate risk: Convertible bonds will lose value if interest rates increase. Rising rates help investors who want to initiate new positions in bonds, but it hurts current bondholders.

Key Considerations for Investing in Convertible Bonds

Convertible bonds, like every investment, have several factors to consider. These are some of the key details you should examine before investing in a convertible bond.

• The issuing company: You will eventually receive common stock from the issuing company. Reviewing the company’s financials can help you gauge if you want to hold onto the stock.
• The conversion price: A lower conversion price relative to the market price can make a convertible bond more attractive.
• The conversion ratio: Knowing how many shares you can get from a convertible bond can help with the decision-making process.
• Portfolio diversification: Investors should not rely on convertible bonds or any singular asset class. If you have too many convertible bonds, it may make sense to spread your funds across other assets. However, convertible bonds can be beneficial if you need extra portfolio diversification and primarily invest in stocks.

Adding Convertible Bonds to Your Portfolio

Convertible bonds offer portfolio diversification and the ability to turn your bond’s principal into common stock. These bonds can reward investors if the underlying stock’s price rises, but they aren’t the best assets if the stock’s price falls. Reviewing your financial goals and portfolio allocation can help you decide if convertible bonds make sense for your portfolio.

Frequently Asked Questions