An Introduction to Convertible Bonds

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.

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. However, some companies issue convertible bonds that convert to a predetermined market value rather than a set number of shares. Known as death spiral debts, these bonds can effectively drive the market share price down as they are converted.

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.

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, they 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.

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.

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.

Example

For example, Twitter (now X) 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. For the year 2014, the price of Twitter (TWTR) stock ranged between around $35 and $55.

To have made a profit on the conversion, the stock would have needed to more than double, to reach that $77.64 level. It certainly had the potential to double as it was a volatile social media stock and, given a low-interest rate environment, the principal protection isn't worth as much as it might otherwise be. Looking back, however, Twitter shares floundered from 2015 through 2020, only reaching the $77 level in 2021.

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.

Example

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 of $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.