Convertible Bonds
What Is A Convertible Bond?
As the name implies, convertible bonds, or converts, give the holder the option to exchange the bond for a predetermined number of shares in the issuing company. When first issued, they act just like regular corporate bonds, albeit with a slightly lower interest rate.
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.
Like any typical bond, convertible bonds have an issue size, issue date, maturity date, maturity value, face value and coupon. They also have the following additional features:
Conversion price: The nominal price per share at which conversion takes place.
Conversion ratio: The number of shares each convertible bond converts into. It may be expressed per bond or on a per centum (per 100) basis.
Parity (Conversion) value: Equity price × Conversion ratio.
Conversion premium: Represent the divergence of the market value of the CB compared to that of the parity value.
Call features: The ability of the issuer (on some bonds) to call a bond early for redemption, sometimes subject to certain share price performance. The intention is to encourage investors to convert early into equity (which has now become worth more than the bond's face value), by threatening repayment in cash for what is now a lower amount.
Issuing convertible bonds is one way for a company to minimize negative investor interpretation of its corporate actions. For example, if an already public company chooses to issue stock, the market usually interprets this as a sign that the company's share price is somewhat overvalued.
To avoid this negative impression, the company may choose to issue convertible bonds, which bondholders will likely convert to equity anyway should the company continue to do well.
From the investor's perspective, a convertible bond has a value-added component built into it; it is essentially a bond with a stock option hidden inside. Thus, it tends to offer a lower rate of return in exchange for the value of the option to trade the bond into stock.