Understanding Convertible Bonds

What Is a Convertible Bond?

A convertible bond is a corporate bond which can be exchanged for a specified amount of common or preferred stock in the corporation that issues it. A convertible bond in X Company cannot be exchanged for common or preferred stock in Z Company unless X Company owns Z Company and this is agreed upon at the time of the original sale. Additionally, at the time of issue, the terms of conversion will be outlined to include the times, prices, and conditions under which the conversion can occur.

What Is a Reverse Convertible Bond?

Reverse convertible bonds are short-term investments directly linked to specific underlying stocks. They have high coupons which offer individual investors a mostly predictable, steady stream of income. There are preset payback choices at maturity that determine whether the investor receives their original investment back, or if they receive a coupon payment with a set number of shares in the collateral stock. If the shares option is taken, they are delivered at a value less than the original investment amount. The earnings potential is limited to the share value.

Why Invest in Convertible Bonds?

An investment in convertible bonds is sometimes seen as the best of both worlds as well as a safety net. As a bondholder, the relationship to the corporation is one of a creditor. Additionally, the bond can be converted to stock (or sold) to gain the rewards of rising stock prices and share value of the corporation. The main advantage is that the bond increases when the stock goes up, or is traded sideways, but doesn’t go down if the stock price falls.

What Is the Difference between Convertible and Callable?

Most convertible bonds are callable; meaning, the company can force (forced conversion) the bondholder to convert their bonds into stock at a time of their choosing. This then converts the bondholder (or creditor) into a stockholder (one who now owns a share of the corporation). On the corporate balance sheet, the money involved in doing this changes from a liability to an asset.

How Does Being Convertible Affect the Investment?

The performance of a convertible bond differs from that of a non-converted bond in several ways.

Convertible bonds generally have a lower interest rate as they accrue value while the price of the underlying stock increases. This gives them the advantage of both bonds and stocks.
Convertible bonds earn interest when the stock is traded down or sideways, as well as when stock prices rise.
Because of the way their value is calculated, convertible bonds offer some security against falling stock prices.
Convertibles are sold at a higher (or premium) rate over stock and should be expected to earn back their premium rate in three to four years.
Convertible bonds can be callable at which point their yield will stop.

More on this topic

What Is the Conversion Ratio?

A key component for considering convertible bonds is the conversion ratio. Sometimes referred to as the conversion premium, the conversion ratio determines how many shares of common stock can be received from each converted bond share. This can be expressed as a ratio (i.e. 30:1, thirty shares of stock for one bond) or as the conversion price (i.e. 25%, which is the price of the stock plus 25%) and is specified at the time of the original issue. To illustrate this mathematical equation, Corporation X sold a bond with a par-value of $1,000; and its stock is currently selling for $100 per share. If the ratio is 25:1, or 25 shares of stock per bond, converting the bond would equate to $2,500 (25 shares x $100 per share). If the conversion price was 25%, the price of the stock would be $125 ($100 + 25%) and one bond would be worth 8 shares. The value of the conversion depends on what the par-value (worth) of the bond is, the current stock price, and the conversion method chosen. It is most likely in a situation such as this one that the ratio would be 10:1, with the worth of the bond at $1,000 and the current stock price at $100. With these new numbers being closer to reality, the ratio would yield 10 shares and the 25% premium would still yield 8.

Additional Resources

·         PricewaterhouseCoopers: http://www.pwc.com
·         NASDAQ: http://www.nasdaq.com
·         Barclays Bank Introduction to Convertible Bonds: http://www.barcap.com/sites/v/index.jsp?vgnextoid=e2a967443090e010VgnVCM1000002e14480aRCRD

Related Resources