How Do Convertible Bonds Work?
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A Hybrid Security
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Convertible bonds have some of the features of both stocks and bonds. As bonds they are debt instruments where the bond holders earn a fixed rate of interest. The conversion feature allows the bonds to be converted into common stock when certain conditions are met. Corporations may prefer to issue convertible bonds because they will have a lower interest rate than straight debt instruments. This helps lower the financing costs of the company. Investors may be interested in convertible issues because they earn steady interest but can still make a profit if the company's common stock increases in value.
How They Work
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Convertible bonds are usually issued in face amounts of $1,000 with a 10- to 20-year maturity. Interest will be paid semiannually or twice a year. The convertible feature allows the owner of the bond to exchange it for a set number of shares of stock of the issuing company. The owner of the bond can elect to convert to stock at any time up to the maturity date of the bond. At maturity, if the bond has not been converted, the owner will receive the face amount of the bond, usually $1,000.
A convertible bond will have a conversion ratio, which is the number of shares for which the bond can be exchanged. Investors use the conversion ratio to calculate several numbers that are important in evaluating the bond. The conversion price is the share price of the conversion. A $1,000 bond with a conversion ratio of 50 will have a conversion price of 1,000 ÷ 50 = $20 per share. The equity value is how much the shares would be worth if the bond were converted at current share price. For example, if the common share currently trades for $10, the equity value of the bond would be 10 x 50 = $500.
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Prices and Values
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Corporate bonds have market prices based on the coupon rate of the bond, current interest rates and the financial health of the issuing company. Convertible bonds have the additional feature of having a value equal to a certain number of common shares of stock.
If the stock price is well below the conversion price, the bond's market price will be based on the bond rate and value. As the stock price gets closer to the conversion price, the bond price will parallel the value of the shares if converted. If the common shares are above the conversion price, the bond value will track very closely with the share price.
Considerations
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The purchase of convertible bonds in amounts of less that $25,000 face value can be difficult and expensive. Investors with smaller amounts should consider mutual funds that specialize in convertible securities.
Convertible preferred shares have features similar to convertible bonds. They have attractive dividend payouts and can be converted to common shares at a certain conversion price. Convertible preferred shares have a lower financial seniority than bonds, and it is not a default if the corporation elects to not pay a dividend.
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