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

Convertible bonds are a unique financial instrument. They combine features of both debt and equity securities. These bonds allow investors to convert their holdings into shares of the issuing company's stock. They appeal to those seeking regular interest payments and potential capital appreciation. There are several types of convertible bonds. Each type has distinct features for different investment strategies and risk appetites. Understanding these types helps investors make informed decisions based on their goals and market conditions. This overview will explore standard convertibles, contingent convertibles, and hybrid convertibles. It will highlight their characteristics and implications for investors.

Mandatory Convertible Bonds

Mandatory convertible bonds require bondholders to convert their bonds into equity shares by a specified date, usually before maturity. This guarantees investors equity in the issuing company at a set conversion price. These bonds often have higher coupon rates to make up for the lack of conversion choice. The conversion usually coincides with major corporate events like mergers or acquisitions. While they can offer significant upside if the company performs well, they also carry risks, including market volatility and potential losses if the stock does poorly.

Contingent Convertible Bonds

Contingent convertible bonds, or CoCos, are mainly issued by financial institutions. They help these institutions strengthen their capital during tough financial times. CoCos automatically convert into equity if certain conditions are met. For example, this can happen if the institution's capital ratio falls. This feature helps stabilize the institution’s balance sheet and allows it to handle losses without outside help. Investors may find CoCos appealing due to their attractive yields. However, they come with significant risks. If the institution struggles financially, investors may have to convert their bonds into shares, which could result in owning part of a failing company.

Exchangeable Bonds

Exchangeable bonds offer more flexibility than standard convertible bonds. These bonds let investors convert their debt into shares of a subsidiary or affiliated company, not just the parent company. This is useful for those wanting to diversify their investments without buying shares directly. Exchangeable bonds usually have a lower coupon rate than mandatory convertibles due to their potential for equity gains. They are attractive to investors who want to benefit from the growth of a related business while still enjoying fixed-income security.

Vanilla Convertible Bonds

Vanilla convertible bonds are the simplest type of convertible bond. They allow bondholders to convert their bonds into common stock at a set price. This option must be exercised within a certain time frame. Investors can convert their bonds if the stock price rises. This gives them a chance to profit from the company's growth. If market conditions are poor, bondholders can keep their bonds and receive regular interest payments. These bonds appeal to conservative investors who want steady income and potential for capital gains.

Reverse Convertible Bonds

Reverse convertible bonds are hybrid financial instruments. They combine features of traditional bonds with a short put option on the issuing company’s stock. Bondholders receive a higher yield than regular bonds but take on risks. At maturity, they may get shares of stock instead of cash. If the stock price drops below a set level, the bondholder could receive depreciated equity. This investment is for those who believe in the asset's long-term potential but accept the risks of falling prices. Reverse convertibles can offer high income, but they are complex and risky.

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.

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.

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.

Conversion Price

A lower conversion price relative to the market price can make a convertible bond more attractive.

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