Convertible bonds are bonds issued by companies that can be converted into shares of the issuing company at the bondholder’s discretion. Convertible bonds typically offer higher yields than common stocks, but their yields are lower than those of regular corporate bonds.
Advantages and Disadvantages of Convertible Bonds
Like regular corporate bonds, convertible bonds pay income to investors. However, unlike bonds, they have the potential to appreciate in price if the company’s stock performs well. The reason for this is simple: since a convertible bond contains the option to convert into stock, a rise in the underlying stock price increases the value of the convertible security.
If the stock performs poorly, the investor may not be able to convert the security into stock and will only have the yield to show for their investment. However, unlike stocks, convertible bonds can only decline to a certain extent – as long as the issuing company remains viable – because they have a specific maturity date when investors will receive their principal. From this standpoint, convertible bonds carry less risk than common stocks.
While convertible bonds have greater upside potential than corporate bonds, they may be more susceptible to losses if the issuing company cannot meet its obligations (or is unable to pay interest and principal on time). For this reason, investors in individual convertible bonds should ensure they conduct extensive credit research.
Example of How a Convertible Bond Works
Suppose ABC Company issues a convertible bond with a five-year maturity and a face value of $1,000 with a 5% coupon. The “conversion ratio” – the number of shares an investor receives if they exercise the option – is 25. The effective conversion price is therefore $40 per share ($1,000 divided by 25).
The investor holds the convertible bond for three years and receives $50 in income each year. At that time, the stock price has risen well above the conversion price and is trading at $60. The investor converts the bond and receives 25 shares at $60 per share, with a total value of $1,500. In this way, the convertible bond offers both income and the opportunity to participate in the rise of the underlying stock price.
It’s important to note that most convertible bonds may be callable, meaning the issuing company can call the bonds and thus cap the profits realized by investors. As a result, convertible bonds do not enjoy the same unlimited potential for appreciation as common stocks.
On the other hand, suppose the stock price of ABC Company weakens during the bond’s tenure. Instead of rising to $60, it falls to $25. In this case, the investor would not convert – the stock price is below the conversion price – and would hold the security until maturity as if it were a corporate bond. In this scenario, the investor receives $250 in income over the five years and then recoups $1,000 at the bond’s maturity.
How to Invest in Convertible Bonds
Investors who are willing to conduct the appropriate research can invest in individual convertible securities through their broker. Several large mutual fund companies offer investment funds that invest in convertible securities.
It’s essential to consider that large portfolios of convertible securities, which represent mutual funds and ETFs, tend to closely track the stock market over time. Consequently, they perform more like high-yield equity funds. These products can provide a diversification element and potential upside compared to traditional bond portfolios, but they are not necessarily the best way to diversify for someone primarily investing in stocks.
Questions
Frequently Asked Questions (FAQs)
How do convertible bonds affect a company’s diluted earnings per share?
Convertible bonds are included in diluted earnings per share (EPS), while basic EPS measurements do not account for that. An investor holding a convertible bond is a potential future shareholder, so their share of earnings is included in the diluted EPS to give potential investors a better idea of what the share offers.
Who can issue convertible bonds?
Convertible bonds convert into shares, so the issuing entity must be a profit-making organization with equity rights. This is the only requirement, but not all companies can issue the same type of convertible bond. The company’s creditworthiness and the broader bond market will determine the specifics of the bond, such as yield and duration.
Was this page helpful?
Thank you for your inquiry! Please let us know why.
Sources:
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
Corporate Finance Institute. “Convertible Bond.”
Fidelity. “Convertibles and Preferreds.”
Source: https://www.thebalancemoney.com/what-are-convertible-bonds-416834
Leave a Reply