What are Convertible Bonds?

A convertible bond is a security, typically ranging between 25 and 30 years in term, that gives its’ owner the right to acquire the issuers common stock directly from the issuer rather than purchasing it in the open market. The terms under which this exchange can occur are detailed out in the bond indenture. The optionality component of this security, which allows for the bond holder to convert debt into equity, results in the bond holder receiving lower yields as compared to non-convertible securities.

Typically, convertible bonds will be classified as subordinated debt and therefore more risky than unsubordinated debt. Subordinated debt holders are lower on the totem pole as far as principal repayment during times of distress for the issuer. In the event of bankruptcy, senior bond holders will be paid their credit balance before subordinated debt holders.

Convertible Bond Structure

A convertible bond has a few key additional features in structure as compared to a typical bond:

Conversion Price — Price paid per share to acquire the common stock of the issuer

Conversion Ratio — This ratio determines the number of shares the bond holder will receive per bond they exchange.

The formula for the conversion ratio is: Par Value of Convertible Security divided by Conversion Price.

Parity — Conversion parity is the point at which a profit, nor loss, would be made at conversion. Basically, parity exists when the conversion ratio at issuance is equal to the convertible security price divided by the market value of the stock.

When the price of the stock increases above the conversion parity price, the convertible security would be subject to price changes relative to the movements of the stock. When this condition exists, stock price appreciation will be reflected in the price of the bond which will allow the bond holder to sell the convertible security for a profit rather than performing a conversion and then selling the stock for a gain.

Conversion Premium — The conversion premium measures the spread between the conversion price and the current market value in percent. For example, if a stock is currently trading at $50 per share and the bond conversion price is $60, the bond would be said to be trading with a 20% conversion premium.

Advantages and Disadvantages to Issuers

Convertible securities tend to be offered by issuers as a means to achieve lower fixed costs for borrowing. Issuers save an average of 2% on the yield that they give their convertible bond holders. For a start-up firm, this is especially helpful; rather than issuing common stock at a 15% to 20% discount to market value on IPO. firms can issue convertible securities which offer lower upfront yields to their borrowers and a conversion premium of 20% to 30% above market value at that time.

Secondly, through the issuance of convertible debt, issuers avoid dilution of their common shares and therefore, higher stock prices for their shareholders. The analysis would need to be done for the issuer to understand if the interest expense of the convertible debt issuance would be less than the cost of diluting the common stock. For start up companies with lower revenues, this is most likely the case.

Issuers may even add their own call protection feature into the bond allowing them to call the bond back in the case that the company starts to increase their earnings; therefore, increasing the stock and the price of the bond. The call feature would allow the issuer to force the bond holder to convert their bonds at a lower price.

For example, suppose the indenture stated that the convertible bond could be exchanged for 10 shares of common stock and also assume that the issuer built in a call provision that would allow them to call the bond away at a bond price of 110. When the bond was issued the stock was trading at $100/share. After a few years of rapid growth, the earnings per share increased dramatically and propelled the stock much higher to $120 per share which also moved the bond price to 120. In this scenario, the issuer would be able to make the bond holder sell the bond back at 110, or $1100 per bond. The value of the conversion is now $1200. Remember, the issuer uses convertibles rather than equity in order to avoid equity dilution which lowers stock price. In this case, the issuer has borrowed funds at a lowered rate, avoided equity dilution, and forced the bond holder to sell the bond at a discount to market. If equity needs to be raised, it can now be done at a higher price.

One key disadvantage to the issuer of a convertible exists if the stock price increases so rapidly that the conversion takes place in a relatively short amount of time. This indicates that the company did not do a good job of valuing themselves; however, it is a win win for both parties nonetheless. A second, and more negative scenario, exists when the common stock actually moves lower after issuance. In this case, the bond holder will not convert to equity as the issuer had hoped.

Advantages and Disadvantages to Convertible Investors

Convertible bonds are a safer investment than buying common stock but can provide the stock like returns. They are less volatile than stocks and their value can only fall to a price where the yield would be equal to that of a non-convertible bond of the same terms. They offer strong downside protection in a bear market. such as the one we experienced between 2000 and 2002 in the stock markets but also allow the investor to take part in the profits as a stock moves higher.

Convertibles can be disadvantageous in the sense that the bond holder will be receiving substantially lower yield to maturity in comparison to the non-convertible equivalent. This is only a concern when the issuer’s equity does not achieve the upward price projections that would make taking the lower yield speculation worthwhile.

Additionally, the ability for speculation is greatly reduced when a call provision is attached to the convertible bond. This limits the upside and will force the bond holder to give up their bond at a discount to market.

Conclusion

Convertible bonds provide the investor with a vehicle which has lower risk and lower yields, yet allows the investor to take advantage of a higher stock price. Upfront research should be done however to understand if the security will work for you. Remember, a convertible sells at a premium to the value of the stock. The bond holder is making a tradeoff; lower yields upfront for anticipated gains in the stock price. If those gains are not achieved, the bond holder will have given up the yield spread between the convertible and non-convertible security.

Make sure you assess the quality of the company you are loaning money to. Does the company have the strength to withstand economic downturns or even recessions. What is the growth potential of the stock? There needs to be enough growth potential to compensate you for the lower yield you took on the convertible bond.