Understanding Convertible Bonds: Definition, Examples, and Key Benefits

What Is a Convertible Bond?

A convertible bond is a unique financial instrument that offers investors the dual benefits of regular interest payments and the potential for equity participation. As a hybrid security, it can be converted into a predetermined number of shares of the issuing company's common stock, usually at the bondholder's discretion. This conversion feature provides investors the flexibility to benefit from stock price appreciation while maintaining the security of a fixed-income investment. However, it also introduces complexities such as sensitivity to interest rates, stock price movements, and the issuer's credit rating. When converting a bond, investors must consider the conversion ratio and price, which are set at issuance and determine the shares received per bond. Let's explore how convertible bonds function, their advantages, and the key distinctions between them and regular bonds.

How Convertible Bonds Operate and Their Features

Convertible bonds are a flexible financing option for companies. A convertible bond offers investors a type of hybrid security, which has features of a bond such as interest payments while also providing the opportunity of owning the stock. This bond's conversion ratio determines how many shares of stock you can get from converting one bond. For example, a 5:1 ratio means that one bond would convert to five shares of common stock.

The conversion price is the price per share at which a convertible security, such as corporate bonds or preferred shares, can be converted into common stock. The conversion price is set when the conversion ratio is decided for a convertible security. The conversion price and ratio can be found in the bond indenture (for convertible bonds) or the security prospectus (for convertible preferred shares). We'll discuss how the conversion ratio is calculated more later in this article.

Bond issuers might also force or exercise their right to call the bond if interest rates are favorable. With a forced conversion, the investor does not have a say in holding or converting their bond.

One version of convertible bonds is known as death spiral debt. With this version, the bond is converted into a fixed dollar value paid in shares. Investors convert their holdings if the stock price drops significantly. This action can further dilute shares and drive the price even further downward.

Comparing Convertible Bonds and Regular Bonds

Convertible bonds and regular bonds share similarities but also have differences. Besides the conversion feature, convertible bonds differ from regular bonds in a few key ways.

First, convertible bondholders can choose to participate in the company's equity. While a regular bond is simply a debt instrument, a convertible bond gives investors the opportunity to benefit from capital appreciation if the company's stock price increases.

Second, convertible bonds typically offer lower interest rates compared to regular bonds because of the added potential for equity participation through conversion. Regular bonds, on the other hand, offer higher interest rates to compensate investors for the absence of equity upside.

Convertible bonds are also often traded on secondary markets, meaning investors can choose to buy or sell them before maturity. With regular bonds, you can do this as well. However, the liquidity of each of these types of bonds may be dramatically different depending on the issuer's credit rating and prevailing market conditions. For example, a single company could issue both types of bonds; depending on that company, investors may have a higher appetite (and therefore drive higher liquidity) for one type over the other.

Last, convertible bonds could theoretically be used as a rebalancing tool for portfolio management. If an investor realizes they've become overweight in debt instruments, they could convert their bond instead of having to sell a position. This flexibility just isn't present with regular bonds.

Key Characteristics of Convertible Bonds

Let's run though the general features of convertible bonds. Much of this information is sprinkled throughout this article; here's a comprehensive list of features you can usually expect when dealing with convertible bonds:

• Conversion Option: It should go without saying, but a convertible bond includes a conversion option. This means the bondholder has the ability to convert the bond into a specified number of shares of the issuing company's stock.
• Interest Payments: As a debt instrument, convertible bonds pay regular interest to bondholders. These coupon payments may have a lower interest rate compared to that of non-convertible bonds because of the added value of the conversion option.
• Maturity Date: Again, like traditional bonds, convertible bonds have a fixed maturity date which is the date when the principal amount of the bond is due to be repaid by the issuer. If the bondholder chooses not to convert the bond into shares, they will receive the bond's face value at maturity.
• Conversion Ratio: The conversion ratio of a convertible bond determines the number of shares that a bondholder will receive upon conversion. This ratio is fixed at the time the bond is issued and is usually expressed as the number of shares per bond. For example, a conversion ratio of 20:1 means that one bond can be converted into 20 shares of the company's stock.
• Conversion Price: The conversion price is the price at which the convertible bond can be converted into shares. It's usually set at a premium to the current market price of the stock at the time of issuance.
• Call and Put Options: Some convertible bonds come with call and put options, adding even more flexibility for both the issuer and the bondholder. A call option allows the issuer to force conversion or redeem the bond before maturity, often at a premium price. A put option allows bondholders to sell the bond back to the issuer at a specified price before maturity, providing an exit strategy if they need liquidity.

Types and Variations of Convertible Bonds

A vanilla convertible bond provides the investor with the choice to hold the bond until maturity or convert it to stock. If the stock price has decreased since the bond's issue date, the investor can hold the bond until maturity and get paid the face value. If the stock price increases significantly, the investor can convert the bond to stock and either hold or sell the stock at their discretion. Ideally, an investor wants to convert the bond to stock when the gain from the stock sale exceeds the face value of the bond plus the total amount of remaining interest payments.

Mandatory convertible bonds are required to be converted by the investor at a particular conversion ratio and price level. On the other hand, a reversible convertible bond gives the company the right to convert the bond to equity shares or keep the bond as a fixed income investment until maturity. If the bond is converted, it is done so at a preset price and conversion ratio.

Calculating the Conversion Price of Convertible Bonds

Typically, the conversion price is set at a premium to the current market price of the stock at the time of issuance. This premium is designed to provide an incentive for investors to convert their bonds into equity, as it ensures that they can acquire shares at a lower price than what they would pay if they were to purchase them on the open market.

The calculation of the conversion price is relatively straightforward. It is calculated by dividing the bond's face value by the conversion ratio. The conversion ratio specifies the number of shares that a bondholder will receive upon conversion. For example, if a convertible bond with a face value of $1,000 has a conversion ratio of 20, the conversion price would be $50 per share ($1,000 divided by 20). This means that for each bond they hold, the bondholder has the right to convert it into 20 shares of the company's stock at a price of $50 per share.

In most cases, the conversion ratio of a convertible bond remains fixed throughout the life of the bond. When a convertible bond is issued, the conversion ratio is established and specified in the bond's terms. This ratio usually doesn't change, so in the example above, the investor could always exchange the bond for 20 shares regardless of share price.

However, when the instrument is created, the conversion rate may be set to be unfavorable to convert. If the conversion price were set at or below the market price of the stock, bondholders could potentially convert their bonds and immediately sell the shares at a profit, effectively deeming the debt instrument process worthless. Therefore, in the example above, 20 shares of stock may be worth $950 in the open market. An investor may simply prefer to hold equity instead of debt, so they accept the conversion price that is less favorable than the market.

Pros and Cons of Investing in Convertible Bonds

Issuing convertible bonds can reduce negative investor sentiment related to issuing new shares. Each time a company issues additional shares or equity, it adds to the number of shares outstanding and dilutes existing investor ownership. The company might issue convertible bonds to avoid negative sentiment. Bondholders can, then, convert into equity shares should the company perform well.

Issuing convertible bonds can also help provide investors with some security in the event of default. A convertible bond protects investors' principal on the downside but allows them to participate in the upside should the underlying company succeed.

A startup company, for example, might have a project that requires a significant amount of capital resulting in a loss in the near-term revenues. However, the project should lead the company to profitability in the future. Convertible bond investors can get back some of their principal upon failure of the company while they can also benefit from capital appreciation, by converting the bonds into equity, if the company is successful.

Investors can enjoy the value-added component built into convertible bonds, meaning they're essentially a bond with a stock option, particularly a call option. A call option is an agreement that gives the option buyer the right—not the obligation—to buy a stock, bond, or other instruments at a specified price within a specific period. However, convertible bonds tend to offer a lower coupon rate or rate of return in exchange for the value of the option to convert the bond into common stock. The lower value is known as the bond floor.

Companies benefit since they can issue debt at lower interest rates than with traditional bond offerings. However, not all companies offer convertible bonds. Also, most convertible bonds are considered to be riskier/more volatile than typical fixed-income instruments.

Tax Implications of Convertible Bonds

There's a few things to keep in mind regarding taxes and convertible bonds. Note that if convertible bonds are held in a tax-advantaged account, the notes to follow may be different.

First, convertible bonds typically pay periodic interest payments to bondholders. This interest income is generally taxable as ordinary income in the year it is received.

If a convertible bond is converted into shares of the issuing company's stock and the investor subsequently sells the shares, any capital gains or losses realized from the sale will likely be subject to capital gains tax. When a convertible bond is converted into shares, the conversion itself is not typically taxable. However, any subsequent capital gains or losses realized from the sale of the shares would be.

Some convertible bonds may be issued at a discount to their face value, resulting in an original issue discount (OID). OID is generally taxable as ordinary income over the life of the bond, regardless of whether you hold the bond to maturity or sells it before maturity. When a convertible bond is converted into shares.

Last, if the convertible bond is converted into shares of stock and the issuing company pays dividends on the shares, any dividends received may be eligible for preferential tax treatment as qualified dividends. Qualified dividends are subject to lower tax rates than ordinary income tax rates for eligible investors.

Practical Example: Understanding Convertible Bonds in Action

As an example, let's say Exxon Mobil Corp. (XOM) issued a convertible bond with a $1,000 face value that pays 4% interest. The bond has a maturity of 10 years and a convertible ratio of 100 shares for every convertible bond.

If the bond is held until maturity, the investor will be paid $1,000 in principal plus $40 in interest for that year. However, the company's shares suddenly spike and are trading at $11 per share. As a result, the 100 shares of stock are worth $1,100 (100 shares x $11 share price), which exceeds the value of the bond. The investor can convert the bond into stock and receive 100 shares, which could be sold in the market for $1,100 in total.

The Bottom Line

Convertible bonds are a type of hybrid security that offer investors the option to convert their bonds into shares of the issuing company's stock at a predetermined conversion price. They provide investors with the potential for capital appreciation through equity participation while also offering downside protection through fixed interest payments.