Convertible Bonds Explained

Bonds tend to get derided as the “boring” part of the stock market – the 32-year-old who leaves the bar at 8PM because they have to be at Target when it opens in the morning.

But, the past few years have seen plenty of action, and a red hot market for one particular type of bond – the convertible bond.

In 2021, convertible debt was such a hot commodity that nearly over $19 billion of convertible bonds were sold within the first seven weeks of the year despite. This number continued throughout the year and we have zero-interest bonds to thank for this.

These zero-interest bonds were sold by big names like Airbnb, Ford, Twitter, DraftKings, Spotify, and even Shake Shack. So why was everyone so excited to buy these bonds? Because convertible bonds offer their investors the chance to convert their bond holdings into stocks.

But should we all start buying convertible bonds? Is this type of bond the best way to diversify our portfolio? As with most forms of investment, the answer is simply “maybe.”

Whether you are hoping to boost your returns, looking to diversify your portfolio, or just trying to figure out what all of the fuss is about, we’re here to help. In this jargon-free guide, we’ll cover all the necessary basics of convertible bonds, what types of convertibles are currently on the market, and why a company might choose to offer one.

What is a Bond? 📙

Bonds, and their parent category of fixed income in general, differ significantly from stocks. Whereas a stock represents a piece of ownership or “equity” in a company, a bond represents ownership of a piece of a borrower’s debt. Bonds are typically issued by either corporations or governmental entities, who could be as small as an individual town or municipality or as large as an entire nation.

Bonds are created or “issued” to raise funds to finance a specific project or activity.  In exchange for their loan, bondholders receive the eventual return of their original investment amount or principal, plus interest.

The amount of interest investors receive is set when the bond is issued and is known as the coupon rate – for example, a $1,000 bond with a coupon rate of 5% would net the bondholder $50 in interest every year for the life of the bond.

Like the coupon rate, a bond’s end date or “maturity date” is also set when the bond is issued.  On the maturity date, the bondholder’s principal will be returned to them.  For example, if we purchased a single bond for $1,000, we will get that $1,000 returned to us on the bond’s maturity date, barring any default on the part of the company.

A default occurs when a company is unable to meet interest payments or pay back their bondholders’ principal.  Although default rates are typically quite low, they do occur – even with large and well-known companies.  For example, German real estate giant Adler Group SA has been given a 77% chance of defaulting within the next five years, an event that could cause headaches for their bondholders and others within their sector and region.   

That being said, the relative security of bond payments is part of why many investors choose to purchase them.  In the event of a bankruptcy, bond repayment is prioritized – which can make bonds attractive for the risk-averse investor.  Because bonds are part of a company’s debt, they are required to be repaid before a company reconciles with their stockholders, making bondholders less likely to lose money if a company fails.

What Are Convertible Bonds? 📗

Like other bonds, convertible bonds offer fixed interest payments on a regular schedule and provide the bondholder with a relatively low-risk investment.  But, convertible bonds also offer the bondholder the ability to “convert” their bond holdings into a set number of shares of stock, meaning that the convertible bondholder could potentially profit from an increase in share price, much like a shareholder would.

Because of this unique convertibility feature, convertible bonds typically offer lower interest rates than other bonds might offer.  Further, convertible bonds are only issued by public, for-profit companies, since governmental or private sources wouldn’t have any stock that the bondholder could exchange their holdings into.

Convertible bonds can be particularly attractive at times when interest rates are rising. Bond prices typically decrease as interest rates rise, because investors can find comparable rates of return with a risk-free bank deposit.  But, convertible bonds tend to be relatively less sensitive to rising interest rates, because their ability to be converted into stock ties them more closely to the issuing company’s equity price.

Why Do Companies Issue These Bonds? 🤔

One reason a company might issue convertible bonds is because they can raise funds at a lower interest rate than regular bonds.  Because convertible bonds can be exchanged for stock, this type of bond is generally issued with a lower coupon rate than other bonds.  For companies raising large amounts of capital, this lower interest rate can mean significant savings as they repay their debt.

Companies may also choose to offer a convertible bond because it allows them to raise capital without potentially diluting shareholder control.  Each new stock offering increases the number of stock shares available in the company, which has the effect of weakening or diluting shares the power of existing shareholders.  

For some companies, greater control over their business is a priority, so they may choose to raise capital in ways that don’t further weaken their own ownership percentage. In addition, existing shareholders are unlikely to be pleased about their own shares becoming diluted, so businesses would be well served to keep them happy and invested.  

By choosing to issue a convertible bond instead of issuing more stock, a company pushes any potential share dilution into the future – buying them valuable time to implement their desired policies and increase their share price to keep their current shareholders satisfied.

How Do Convertible Bonds Work? 👷‍♂️

Convertible bonds work much like regular bonds – bondholders purchase them for a set price or par value and are entitled to regularly scheduled interest at their specified coupon rate. As with other bonds, convertible bonds are issued with a predetermined maturation date where the full principal will be paid back.

However, convertible bonds also come with predetermined conditions that allow either the bondholder – or the issuing company themselves – to exchange their bond for a set number of stock shares. The convertibility of these types of bonds mean that the convertible bondholder benefits from much of the protections offered by a bond while retaining a limited ability to benefit if the company’s stock price increases.

If a company’s stock decreases in price, the convertible bondholder can treat their holding like a regular bond – reaping the interest payments and the return of the principal after the bond matures. But if a company’s stock increases in price, a convertible bondholder can choose to exchange their bond for shares of stock and potentially sell them for more than they would have received over the lifetime of the bond.

Conversion Ratio 🧮

The conversion ratio is the predetermined number of shares that a convertible bond can be exchanged for.  For example, a bond with a conversion ratio of 100 may be exchanged for one hundred shares of stock.

Using our bond’s conversion ratio, we can determine the conversion price – the amount that each share of stock would be worth to us, given the price we paid for our convertible bond.  Convertible bonds are typically issued with a par value or initial price of $1,000. Using our conversion ratio of 100, our conversion price would be $10 per share, since our $1,000 bond is divided into 100 shares of stock.

Once we have determined the conversion price for our convertible bond, we can determine whether it is more profitable to sell or retain our holdings in bond form.  For example, if our $1,000 bond has a 5% coupon rate and a maturity length of 5 years, we will net $1,250 over the course of the bond’s lifespan.

If we chose to convert our bond while the company’s stock price is selling at $9 per share, we would lose money, since our $1,000 bond would now be converted into 100 shares of stock that we could only sell on the market for $900 total.   

But, if the company’s stock price jumped to $13 per share, we could convert our bond into 100 shares of stock that would be worth $1,300, more than the $1,250 that we would earn over the life of the bond. 

It is worth pointing out that as convertible bondholders, we don’t necessarily have to sell our stock immediately after we convert our holdings into it. If we feel strongly about the company’s performance, we could convert our bond into stock and remain invested in the company – albeit as a stockholder with ownership rights, rather than as a bondholder. This difference in ownership rights is the primary difference among stocks and bonds altogether.

When and Why Do They Convert? 🧐

Each convertible bond comes with unique specifications about when and how a bondholder can convert their bonds into stock. Some convertibles only allow bondholders to convert after a specific length of time or during set time periods within the lifespan of the bond.  

Other convertible bonds will try to delay conversion by setting a lower conversion ratio – thus ensuring that the company’s stock price will need to increase significantly in order for conversion to make financial sense for the bondholder.

Importantly, some convertible bonds are callable, meaning that the issuing company can force the bondholder to convert their bond into stock if the stock price sharply increases or if the company is doing exceptionally well.  These bond callbacks serve to cap the upward potential that the bondholder can receive for increases in share price.

Because each convertible bond offers a unique set of rules and restrictions about conversion into stock, it is crucial that interested investors do their research.  Information about converting each bond will be included in its bond indenture, the legal contract that comes with each bond that states the rights and obligations of both the investor and the issuing company.

Preferred Stock vs. Convertible Bonds ⚔

Both preferred stock and convertible bonds are considered to be a type of “hybrid” asset, meaning that they possess characteristics of both bonds and stocks. Both assets can be attractive for fixed-income investors, since they offer regularly-scheduled payments, either in the form of interest for convertible bonds or dividends for preferred stock.

Another important quality to be aware of is that both preferred stocks and convertible bonds are able to be rated by the major credit agencies, something that can bring peace of mind to investors not wanting to take on more risk than they bargained for.  But for a wide variety of reasons, not all issuing companies choose to get their convertible bond or preferred stock rated, so investors should be sure to do their homework before gambling on an unrated offering.  

One important distinction between convertible bonds and preferred stock is that in the case of a bankruptcy, convertible bondholders will be repaid ahead of preferred stockholders. Bankruptcy law requires that a company settles its debt obligations before it disburses any remaining funds to their equity holders.

Further, preferred stock may have more potential for equity gains than a convertible bond would.  Companies intend their convertible bonds to be more valuable to the bondholder as a bond, rather than as a piece of equity. 

Bondholders should carefully study the circumstances in which they are able to convert their holdings to stock, since each bond has unique specifications and it might not be easy to convert when stock prices are soaring.

Different Types of Convertible Bonds 🗃

Although there is no formal classification system for convertible bonds, there are a few different common types that we’ll discuss below. Some types of convertible bonds may be better suited for certain investors over others, so we’ll be sure to point out the pros and cons of each specific type.

Vanilla 📜

Vanilla convertible bonds, which are also referred to as “standard” convertible bonds, are the most common type on the market and are issued with a predetermined conversion ratio and price. Vanilla bondholders have the option to hold the bond until maturity or convert it to stock.

If the company’s stock has remained the same or decreased since the issue date, bondholders can choose to hold the bond until it matures, at which point they’d receive the full par value.  Alternatively, if the price of the stock has gone up significantly, bondholders can choose to convert their holdings and either sell the stock on the secondary market or continue to hold it as part of their investments.

Although each convertible bond has unique features, vanilla convertible bonds tend to give more control to the bondholder about when and how they convert their holdings into stock, rather than the issuing company.  For most investors, a vanilla convertible bond is likely to be the best choice, since the ability to decide how we convert our bond holdings into stock is why we are interested in convertible bonds in the first place. 

Mandatory Convertibles 💱

In contrast to vanilla convertible bonds, mandatory convertibles require bondholders to convert their bonds into shares of stock at or before the maturity date.  This conversion happens using a predetermined conversion ratio, laid out in the bond’s indenture documents.

Because conversion to stock is mandatory for this type of convertible, investors should be aware that their returns are only guaranteed until the conversion happens.  This means that investors trade the likely return of their principal investment for the potential for larger gains once their bond has been converted into stock.

Because mandatory convertibles are riskier, they tend to offer higher coupon rates to compensate.  While that can be tempting for many investors, we have to be sure that we fully understand the conversion terms our investment will be subject to – are our holdings converted using a conversion ratio? Or are they converted at a certain price?  The details can be extremely important with this type of convertible.

Reverse Convertibles 💵

In sharp contrast to vanilla convertibles, a reverse convertible bond allows the issuing company to decide if an investor’s bond will be converted into shares of stock or repaid in full with cash.

In the bond’s indenture, a reverse convertible will specify a set date on which the conversion to either cash or equity will take place. Importantly, it will also specify the conversion ratio that will be applied as well as which company’s stock the bondholder’s holdings will be converted into.  That’s right – with a reverse convertible, bondholders may find their bond exchanged into stock from multiple companies.

For adventurous investors, reverse convertibles can be attractive because they typically have higher coupon rates and shorter maturity lengths. But those perks are offered to offset the increased risk that is inherent to this kind of product. At the prespecified conversion date, investors may be forced to accept shares of equity that may have decreased in value during the life of the bond. 

While investors might be tempted by the higher interest rates, reverse convertibles are extremely complex products that aren’t well suited for beginner investors.  Because the choice to exchange their bonds into either cash or stock shares is left exclusively up to the issuing company, investors choosing reverse convertibles should make sure they are comfortable with owning the underlying stock that their holdings could be converted into.

Example of a Convertible Bond 📝

In 2021, convertible bonds were an extremely popular offering, particularly for technology companies like Spotify, Affirm, or Peloton. In fact, convertible bonds were so popular that companies were even able to offer a zero coupon convertible bond and still have buyers!  Let’s dig into a hypothetical convertible bond offered by a technology company.

In May 2021, Tech Corp offered a vanilla convertible bond with a par value of $1,000.  Because the market for convertibles was in their favor and the maturity length was a relatively short three years, Tech Corp was able to get away with a 3% coupon rate.  At issuance, Tech Corp’s convertible offered a conversion ratio of 8 and their current share price was $100.

If we purchased Tech Corp’s bond and held it until its full maturity, we would receive the return of our $1,000 principal and interest payments of $30 per year throughout the lifetime of the bond, receiving a total of $1,090 by the maturity date.

If we were interested in converting our bond, we’d first need to find our conversion price. Now remember, our conversion price comes from dividing the par value of our bond, $1,000 in this instance, by our conversion ratio of 8. We’d find that our conversion price is $125 per share, meaning that Tech Corp’s stock price is going to have to increase by more than 25% for our conversion to break even with our par value.

But, let’s not forget that retaining our convertible as a bond means that we gain interest payments of $90 over the life of the bond. If we divide the total lifetime value of the bond ($1,090) by our conversion ratio, we can see that Tech Corp’s stock would need to be priced higher than $136.25 per share before our conversion begins to make sense.

Pros and Cons of Convertible Bonds ⚖

On the positive side, convertible bonds can provide investors with the relative security of a bond without sacrificing all potential upside if a company’s share price increases. Particularly for an investor whose portfolio is focused on income generation, convertibles could be a potential way to boost an investor’s overall rate of returns.  

Keep in mind that while high-yield dividends have produced 5% returns over the past ten years, the U.S. equity market has seen annualized returns of 14.6%, gains that a bond-heavy investor largely missed out on.

Particularly in periods of rising interest rates, convertible bonds can offer more protection than other forms of bonds, since convertible’s exposure to stock prices means that they tend to track more closely to overall stock performance.  This is not to suggest that convertible bonds aren’t still sensitive to rising interest rates on the secondary market – they definitely are, albeit slightly less so than other types of corporate bonds.

But, investors need to be aware that any bond still comes with an inherent default risk. According to international credit rating agency Moody’s, the trailing 12-month global speculative-grade default rate as of January 2022 is a mere 1.8%, a fairly low number given the tumultuous forces that have been impacting markets.

Another drawback to convertible bonds is that they tend to come with lower coupon rates than an investor could find elsewhere in the bond market. Investors should be clear why they are interested in purchasing a convertible bond – is another bond with a higher interest rate a better fit? If investors feel particularly strongly about an individual company, it might be worth examining if investing directly in their stock would be a better choice.

Interested investors should also make sure that they take the time to research the company and read their convertible bond’s indenture document, so that they understand exactly how they can convert their bonds, should they choose to exercise that option. What is the conversion ratio?  Is there a specified date that an investor must convert by?

Benefits for Issuers 🌟

For companies that issue convertible bonds, the primary benefit is the ability to raise capital at a lower interest rate than a traditional bond. Because convertible bonds offer the value-added option to convert into equity shares, investors are willing to accept a lower coupon rate than they would for other bonds.  For large financing rounds, the savings in interest payments can be substantial.

Convertible bonds can also be beneficial because they can be used to delay or diminish share dilution. Stock grants the holder a role in corporate governance and some companies prefer a high degree of control over their operations, rather than being more beholden to shareholders.  Through setting a low conversion rate, companies can incentivize bondholders to retain their bonds as a security product, rather than converting them into shares of stock.

But both issuers and investors have to be careful that they don’t go overboard on the level of debt that they are undertaking.  If a company’s stock price fails to rise to the point where conversion to stock is the more lucrative option, the company is then on the hook for repaying the balance of those convertible bonds. This can be a huge sum of money that must be paid back all at once or risk default.

Benefits for Investors 💰

For investors, convertible stock can be beneficial if an investor has particularly strong sentiments towards a specific company.  Although potential upside is typically limited due to a company’s ability to call or forcibly convert their holdings into stock, an investor can still reap some benefit if a company’s share price increases.

Convertible stock can be particularly beneficial if an investor is interested in investing in a startup with high growth potential.  Startups tend to be inherently volatile, so a convertible bond might be a good way to protect the investor’s principal while retaining the potential for further profit if the company is successful.

As a final point, convertible bonds might be a good option if an investor has a bond-heavy portfolio and is looking to increase their rate of returns without taking on undue risk.  A convertible offers a risk-averse investor exposure to potential equity gains, while still having the enhanced protection that comes with the bond class.

How To Buy Convertible Bonds 👨‍🏫

Interested investors can purchase individual bonds through reputable stock brokerages and should specifically look for a broker that has a bond desk and specializes in convertibles. Investors should be aware that many brokerages don’t offer direct investments in convertibles because they are not as common as other types of bonds. 

Alternatively, investors might look at purchasing these securities through the leading ETF brokers, as this is another way of investing in convertible bonds. But, investors should be aware that these funds tend to be correlated with overall stock market performance and may not be a suitable choice if an investor is trying to beat overall market returns.

Regardless of whether we choose to buy individual bonds or purchase a pooled convertible bond mutual fund or ETF, we have to be prepared to research the bonds we hope to invest in.  Potential bondholders need to review the terms included in the bond indenture, as well as checking the credit ratings of the convertible bond being offered.

Final Word: Should You Buy These Assets? 🏁

Convertible bonds can be a good investment for the right kind of investor.  That being said, the complexity of this product can make it a better fit for more experienced investors.  Further, convertible bonds tend to have a par value of $1,000, which can make investing in them inaccessible for beginners or investors who are investing with smaller dollar amounts.  

If an investor has particularly strong convictions about a specific company, it might be worth investing in their individual convertible bond.  Convertible bonds can help protect an investor on the downside, while offering the opportunity for limited upside potential.  But even in those instances, investors should ask themselves why they are interested in pursuing a convertible bond, as opposed to investing in the company’s stock directly.  

For many investors, a diversified mutual fund or ETF of convertible bonds may be a better fit than investing in a single company’s convertibles.  These funds tend to track the stock market fairly closely over time and can perform similarly to a high-dividend equity fund.  That being said, a convertible fund may not help to diversify an investor’s portfolio if they are already highly invested in stocks.

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