Convertible Bonds

What Are Convertible Bonds?

Convertible bonds are corporate bonds that the bondholder can convert into a predetermined number of shares of the issuing company.

Deeper Definition

A convertible bond is similar to a common bond because it pays the holder a fixed-income interest and maturity date. However, what distinguishes it from the common bond is that the holders can convert it into the issuing company’s shares. Essentially, these types of bonds possess the features of both debt and equity. It stays as a debt if an investor decides not to convert it into shares, and it becomes equity if an investor converts it into stocks.

The companies that issue convertible bonds are typically those with a low credit rating and high growth potential. Investors who purchase these bonds get paid a fixed or floating interest. However, the interest rate is often lower than that of similar non-convertible bonds because of the additional value of converting the bond to stock. Usually, the bond’s conversion ratio determines how many shares a bondholder gets when converting the bond to shares.  For instance, if the bond conversion ratio is 4:1. This means for each bond, the holder receives four shares of common stock.

There are two kinds of convertible bonds, they include:

• Vanilla convertible bonds: Investors who hold this kind of bond have the choice of keeping it until maturity or converting it to stock, depending on which is more profitable. For instance, if the company’s stock value decreases, an investor would keep the bond until maturity. On the other hand, if the company’s stock value increases, an investor is likely to convert the bond to stocks.

• Mandatory convertible bonds: Investors with these bonds are obligated to convert their bonds to shares at a particular conversion ratio and price level at maturity. 

• Reversible convertible bond: This allows the company that issued the bond to repurchase it in cash or convert it to stocks at a predetermined conversion price and the rate at the maturity date.

Convertible Bonds Example

Kim bought the bonds of a new promising health care company. They come with an option that allows her to convert them into the company’s shares if she wants. After five years, the company’s stock value increases, and Kim converts her bonds to shares. She sells some of the stocks and holds on to some, hoping the value will go higher in the future.