11/21/2020 An Introduction to Convertible Bonds

BONDS CONVERTIBLE NOTES

An Introduction to Convertible Bonds

By NICK K. LIOUDIS | Updated Oct 9, 2019

TABLE OF CONTENTS
What Is a Convertible Bond?
Why Companies Issue Them
Conversion Ratios
Convertible Bond Downsides
EXPAND +
Convertible Bond Numbers

New players in the investing game often ask what convertible bonds are, and whether they
are bonds or stocks. The answer is that they can be both, but not at the same time.

Essentially, convertible bonds are corporate bonds that can be converted by the holder into
the common stock of the issuing company. Below, we'll cover the basics of these chameleon-
like securities as well as their upsides and downsides.

KEY TAKEAWAYS
Convertible bonds are corporate bonds that can be exchanged for common stock in
the issuing company.
Companies issue convertible bonds to lower the coupon rate on debt and to delay
dilution.
A bond's conversion ratio determines how many shares an investor will get for it.
Companies can force conversion of the bonds if the stock price is higher than if the
bond were to be redeemed.

What Is a Convertible Bond?

As the name implies, a convertible bond gives the holder the option to convert or exchange it
for a predetermined number of shares in the issuing company. When issued, they act just like
regular corporate bonds, albeit with a slightly lower interest rate.

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Because convertibles can be changed into stock and, thus, benefit from a rise in the price of
the underlying stock, companies offer lower yields on convertibles. If the stock performs
poorly, there is no conversion and an investor is stuck with the bond's sub-par return—below
what a non-convertible corporate bond would get. As always, there is a tradeoff between risk
and return.

Why Do Companies Issue Convertible Bonds?

Companies issue convertible bonds or debentures for two main reasons. The first is to lower
the coupon rate on debt. Investors will generally accept a lower coupon rate on a convertible
bond, compared with the coupon rate on an otherwise identical regular bond, because of its
conversion feature. This enables the issuer to save on interest expenses, which can be
substantial in the case of a large bond issue. 

FAST FACT
A vanilla convertible bond allows the investor to hold it until maturity or
convert it to stock.

The second reason is to delay dilution. Raising capital through issuing convertible bonds
rather than equity allows the issuer to delay dilution to its equity holders. A company may be
in a situation wherein it prefers to issue a debt security in the medium-term—partly since
interest expense is tax-deductible—but is comfortable with dilution over the longer term
because it expects its net income and share price to grow substantially over this time frame.
In this case, it can force conversion at the higher share price, assuming the stock has indeed
risen past that level. 

Conversion Ratio of Convertible Bonds

The conversion ratio—also called the conversion premium—determines how many shares
can be converted from each bond. This can be expressed as a ratio or as the conversion price
and is specified in the indenture along with other provisions.

For example, a conversion ratio of 45:1 means one bond—with a $1,000 par value—can be
exchanged for 45 shares of stock. Or it may be specified at a 50% premium, meaning if the
investor chooses to convert the shares, he or she will have to pay the price of the common
stock at the time of issuance plus 50%.

The chart below shows the performance of a convertible bond as the stock price rises. Notice
the price of the bond begins to rise as the stock price approaches the conversion price. At this
point, your convertible performs similarly to a stock option. As the stock price moves up or
becomes extremely volatile, so does your bond.
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Image by Julie Bang © Investopedia 2019

It is important to remember that convertible bonds closely follow the underlying share price.
The exception occurs when the share price goes down substantially. In this case, at the time
of the bond's maturity, bondholders would receive no less than the par value.

The Downside of Convertible Bonds: Forced Conversion 

One downside of convertible bonds is that the issuing company has the right to call the
bonds. In other words, the company has the right to forcibly convert them. Forced
conversion usually occurs when the price of the stock is higher than the amount it would be if
the bond were redeemed. Alternatively, it may also occur at the bond's call date.

Important: A reversible convertible bond allows the company to convert it to

shares or keep it as a fixed income investment until maturity.

This attribute caps the capital appreciation potential of a convertible bond. The sky is not the
limit with convertibles as it is with common stock.

For example, Twitter (TWTR) issued a convertible bond, raising $1.8 billion in September
2014. The notes were in two tranches, a five-year due in 2019 with a 0.25% interest rate, and a
seven-year due in 2021 at 1%. The conversion rate is 12.8793 shares per $1,000, which at the
time was about $77.64 per share. The price of the stock has ranged between $35 and $56 over
the last year.
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To make a profit on the conversion, one would have to see the stock more than double from
the $35 to $40 range. The stock certainly could double in short order, but clearly, it's a volatile
ride. And given a low-interest rate environment, the principal protection isn't worth as much
as it might otherwise be.

The Numbers on Convertible Bonds

Convertible bonds are rather complex securities for a few reasons. First, they have the
characteristics of both bonds and stocks, confusing investors right off the bat. Then you have
to weigh in the factors affecting their price. These factors are a mixture of what is happening
in the interest-rate climate, which affects bond pricing, and the market for the underlying
stock, which affects the price of the stock.

Then there's the fact that these bonds can be called by the issuer at a certain price that
insulates the issuer from any dramatic spike in the share price. All of these factors are
important when pricing convertibles.

For example, suppose that TSJ Sports issues $10 million in three-year convertible bonds with
a 5% yield and a 25% premium. This means TSJ will have to pay $500,000 in interest
annually, or a total $1.5 million over the life of the converts.

If TSJ's stock was trading at $40 at the time of the convertible bonds issue, investors would
have the option of converting those bonds for shares at a price of $50—$40 x 1.25 = $50.

So, if the stock was trading at $55 by the bond's expiration date, that $5 difference per share
is profit for the investor. However, there is usually a cap on the amount the stock can
appreciate through the issuer's callable provision. For instance, TSJ executives won't allow
the share price to surge to $100 without calling their bonds and capping investors' profits.

Alternatively, if the stock price tanks to $25, the convert holders would still be paid the face
value of the $1,000 bond at maturity. This means while convertible bonds limit the risk if the
stock price plummets, they also limit exposure to upside price movement if the common
stock soars.

The Bottom Line

Getting caught up in all the details and intricacies of convertible bonds can make them
appear more complex than they really are. At their most basic, convertibles provide a sort of
security blanket for investors wishing to participate in the growth of a particular company
they're unsure of, and by investing in convertibles, you are limiting your downside risk at the
expense of limiting your upside potential.

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Related Terms
Understanding the Conversion Ratio
The conversion ratio is the number of common shares received at the time of conversion for each
convertible security. more

Exchangeable Debt
An exchangeable debt is a type of hybrid debt security that can be converted into the shares of a
company other than the issuing company. more

Convertible Subordinate Note Definition

A convertible subordinate is a convertible bond, but which is junior to more senior convertible notes.
more

Conversion Value Definition

The conversion value is that of a convertible security, if its call option is exercised. more

Convertible Debentures Definition

A convertible debenture is a type of long-term debt issued by a company that can be converted into
stock after a specified period. more

How Contingent Convertibles – CoCos Work and the Risks

Contingent convertibles (CoCos) are similar to traditional convertible bonds in that there is a strike
price, which is the cost of the stock when the bond converts into stock. more

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