What is a Convertible Bond? Definition & Example

TheStreet

Are you looking for the security of a fixed-income investment that has a potential to be changed into stock? Consider a convertible bond. 

According to Charles Schwab & Co. Inc., convertible bonds tend to offer lower yields than traditional bonds, but have potential to generate higher total returns if the underlying stock's price rises.

What is a Convertible Bond?

First, it helps to know what a bond is, and what a bond isn't. A bond isn't an investment in a corporation the way a stock or becoming a shareholder is. A bond is essentially a promissory note. 

When you buy a corporate bond, you aren't buying or investing in ownership of a company, the way you are when you are as a shareholder. You have no voting rights. You merely lend a corporation your money, for its purposes, in exchange for monthly payments of interest on what they borrow from you, and full payment at a bond's maturity of the amount they borrowed from you when you purchased their bond. 

A convertible bond is similar to a regular corporate bond. It pays a coupon - monthly interest - and pays the face or "par" value at maturity. But, because it can be changed into something else - investment in, rather than lending to, a corporation - the interest rate offered on a convertible bond is frequently less than a straight, nonconvertible corporate bond. 

A convertible bond acts more like a bond than a stock until or unless the bond holder - lender - or the issuer chooses to convert it into stock or share ownership. A convertible bond is a corporate bond that an investor can convert into a set number of shares of a corporation, giving the holder after conversion the same rights as any shareholder.

How Do Convertible Bonds Work? 

There are a pair of factors that go into a considering whether to invest in a convertible bond. 

They are conversion price, and conversion ratio. 

The conversion price is the share price at which the convertible bond can be converted into common stock. Upon issuance, the conversion price is usually set, and the bonds themselves are usually issued when the current price of the underlying stock is below that of the conversion price. 

The amount by which the price of the stock is below the conversion price is called the conversion premium. 

The conversion ratio is the amount of shares of common stock for which the convertible bond can be exchanged. 

To find the conversion ratio, you divide the par or face value of the bond, typically $1,000, by the conversion price. 

For example, if the conversion price is $25, and the bond's par value is $1,000, the conversion ratio is 40:1. Meaning each convertible bond can be converted into 40 shares of common stock once the stock price of $25 is reached. 

What are the Types of Convertible Bonds?

There really is no formal or official classification of convertible bonds, according to the Corporate Finance Institute, the way there are with other fixed income instruments. But bond underwriters often refer to three different kinds of convertible bonds: 'vanilla' convertible bonds, mandatory convertibles and reverse convertibles.

Vanilla Convertibles

These are called 'vanilla' because they are the most common type of convertible bond. Investors get the right to convert their bonds to a certain number of shares at a predetermined conversion price and rate at the date of the bond's maturity. Because these are bonds that can be converted into stocks, they may pay coupon payments to service the debt during the bond's life, and have a fixed maturity date at which investors are entitled to receive the nominal value of the bond, if they choose to not convert the bond.

Mandatory Convertibles

As the name indicates, these are bonds that investors are obliged to convert to shares at maturity. These bonds usually carry two conversion prices: the first price delimits the price at which an investor will receive the equivalent of the bond's par value in shares, while the second one sets a limit to the price an investor can receive above the par value.

Reverse Convertible

A reverse convertible bond gives an investor the option to either buy back the bond in cash or convert it into equity at a predetermined conversion price and rate at maturity. It also, however, allows the issuer to convert the bond to shares or keep it as a fixed income investment until maturity, capping the capital appreciation potential of the convertible bond.

Forced Convertible

The issuer has a right to call the bonds, meaning it can forcibly convert them. Forced conversion occurs most often when the price of the stock underlying the bonds is higher than it would be if the bond were redeemed, or at the bond's maturity date.

Twitter, for instance, issued a convertible bond in September 2014, from which it raised $1.8 billion. The bonds were issued in two tranches - a 5-year due in 2019 with a 0.25% coupon, and a 7-year with a coupon payment of 1% due to mature in 2021.

The conversion rate was about 12.8793 shares per $1,000. That was when the shares were worth about $77.64 each, according to a regulatory filing by Twitter. The stock's price has ranged between $26 and $46 over the past year.

For bondholders to make a profit on the conversion, the stock would have to more than double from the $35-$40 range.

So, in June of 2018, Twitter announced plans to issue another tranche of convertible bonds, due to mature in 2024, and dedicated a portion of the proceeds to pay cash to holders of the previous note due to mature in 2019 rather than allow them to be converted, because, as Barron's said, "the conversion feature is considerably out of the money, with a conversion price of more than $77 a share..."

In its release on the 2018 convertible notes, Twitter said: 'Conversions of the notes will be settled in cash, shares of Twitter's common stock or a combination thereof, at Twitter's election.'

Advantages & Disadvantages of Convertible Bonds 

Pros: 

  • Corporations like the lower interest rates paid to bondholders on convertible bonds compared to regular bonds, saving them money on how much they have to pay out to investors.
  • The bond issuer also no longer needs to continue making fixed interest payments after conversion, which has the effect of reducing the issuer's debt upon conversion.
  • Conversion does not increase the issuer's number of outstanding shares, which would reduce the issuer's earnings per share as in a stock offering or sale.
  • Investors like them because, in the event of a liquidation of debts and assets, bondholders who haven't converted their bonds maintain priority as debtors over common stock holders.
  • Unconverted convertible bonds continue to pay a fixed rate of interest, and the par value of the bond will be returned (paid) at maturity. Except in the case of a default.
  • Interest payments on all bonds usually have a higher priority of payment from corporations than dividends to which holders of common stock may be entitled.
  • Conversion of a convertible bond to stock is not taxable - as converting from bond holding to shareholding is not considered 'buying and selling.'

Cons:

  • Convertible bonds may be more susceptible to market risk than nonconvertible bonds, because of potential fluctuation in the underlying value of the company's stock.
  • A number of conversions could affect earnings per share, because of the amount of shareholders increasing for earnings distribution.
  • Also, shareholders can gain control of a company through the voting rights that come with stock converted by former convertible bondholders.