A convertible bond is a type of debt security that can be converted into equity by exchanging the bond for a fixed number of company stock shares. Conversion is typically done at the discretion of the investor.
Convertible bonds offer a flexible way for companies to raise capital. They are also very attractive to investors, as a convertible bond is essentially a conventional bond with a stock call option attached to it.
As a tradeoff for the added benefit of convertibility, convertible bonds typically have lower coupon rates than traditional bonds. Convertible bonds can be held in brokerage accounts, as well as retirement planning accounts such as IRAs.
Why do Companies Issue Convertible Bonds?
As with any debt or equity security, companies issue convertible bonds in order to raise capital. Issuing additional shares of stock, however, can sometimes result in negative investor perception. This is because the investing public usually sees the issuance of additional stock by a public company as an acknowledgment that the stock is overvalued. Issuing bonds that are likely to be converted to equity is a way to avoid this negative perception by investors. Expecting bondholders to convert their bonds into stock shares also signals that management is confident that the company’s stock will rise in the future.
Because convertible bonds pay lower coupon rates than traditional bonds, issuing convertibles allows companies to save money on their borrowing costs.
Why are Convertible Bonds Attractive to Investors?
Convertible bonds are attractive to investors, including those investing for retirement planning, primarily because of the interest income they provide. Aside from that, they give investors the opportunity to participate in the upside of company performance, while also having downside protection. If the stock really takes off, converting the bond can result in a real windfall for the investor. If things don’t go so well with the stock, however, a bondholder can still recover their principal at the time the bond matures.
Example of a Convertible Bond
Convertible bonds are sort of an abstract concept, so let’s look at an example of how one could work. ABC Corporation is issuing convertible bonds at a par value of $1,000, an interest rate of 4%, and a conversion rate of ten shares. The stock is currently trading at $10 per share, so the converted value is $1,000. In this case, it makes sense to hang onto the bond and collect the 4% annual interest.
A few months later, ABC reports strong quarterly earnings, and the stock price rises to $15 per share. The converted value of the bond is now $1,500. You convert the bond, sell your shares, and walk away with a profit of $500 – plus whatever interest you had earned up to that point.
What if you didn’t convert, though and things turned around for ABC? Let’s say the good times didn’t last, and by the time your bond matured, ABC stock was trading at $5 per share. At this time, assuming ABC was still fulfilling their obligations, you would walk away with your original $1,000 investment, and you would have received 4% interest for every year of the bond’s term. That’s a lot better of a scenario than if you had bought ten shares of stock at $10 apiece and were now looking at a 50% loss.