Investing in convertible bonds is like expecting a reliable income and at the same time, crossing fingers for a potential capital appreciation.

Convertible bonds act like regular corporate bonds when issued. They gain an interest payment as a traditional bond does.

But, what sets convertibles apart is that you can also convert them into a certain number of common stocks or equity shares of the issuing company.

With this hybrid security, convertible bonds have become a favorable financing option for many high-growth companies and investors alike. Typically, convertibles offer higher yields compared to the common stock, although they have lower gains than straight corporate bonds.

Let’s delve deeper into the characteristics of convertible bonds, and investigate how you may take advantage of this hybrid investment.

Let’s Start Defining

Convertible bonds are a type of fixed-income debt security. Similar to regular corporate bonds, they pay income to investors like you upon the maturity date.

Unlike traditional bonds, though, convertibles have the potential to increase in price as the company’s stock performs better. You may convert the bond into stock if it’s the favorable choice, or take it as is, receiving the bond’s face value plus all of the remaining unpaid interest at maturity.

Upon conversion, the convertible bond loses its debt features, embracing only its equity features.

A convertible bond is characterized by its par value, i.e., the face value of the bond, the coupon rate or the interest rate paid on the face value, and the conversion ratio.

Conversion Ratio

The conversion ratio determines the equivalent shares of stock for every bond converted. A ratio of 15 or 15:1 means that one bond converts to 15 shares of stock.

Consider the following illustration of an investor buying a convertible bond from Company A.

The conversion from a convertible bond into stock can take place at particular instances during the bond’s existence. Usually, the conversion occurs at the discretion of the bondholder, depending on the type of convertible bond.

Conversion Price

Sometimes, the trust indenture or bond agreement expresses the conversion feature in terms of the conversion price. It’s the price at which the par value of the bond is equal to the number of converted shares. Simply put, it’s the bond’s price divided by the conversion ratio.

From the example above, the conversion price would be at $50.

The calculation is illustrated in the upper left portion of the chart below.

Increasing the conversion ratio decreases the conversion price. In the same way, a lower conversion ratio results in a higher conversion price.

Upon issuance of the convertible bonds, the underlying stock’s price is typically below the conversion price.

Conversion Parity Price

The conversion parity price, on the other hand, is the break-even price. It’s equal to the market value of the convertible bond divided by the conversion ratio. So, it’s the amount paid for each share at the time you’re exercising the option of converting to stock.

If the bond is currently valued at $1200, and the conversion ratio is at 20, then the conversion parity price would be $60.

(You’ll find this calculation in the upper right portion of the chart above.)

The conversion parity price is important since, as long as the shares of stock haven’t reached that price, it wouldn’t be worth converting the bond into stock. In other words, it’s the trigger price or the price at which it starts to make sense to opt for conversion.

Conversion Value

Meanwhile, the conversion value is equal to the conversion ratio multiplied by the current share price of the stock. If Company A’s stock price is at $40 per share, then the conversion value is $800.

(Again, this is shown in the chart above — specifically in the middle portion.)

Conversion Premium

The difference between the conversion value and the current market value of the bond is known as the conversion premium, i.e., the premium over the conversion value. If Company A’s bond is currently selling at $1000, then the conversion premium is simply $200.

(This is illustrated in the final equation in the above chart.)

This premium represents the potential of the stock price to increase further before the conversion date.

Now, performance-wise, conversion bonds have been more correlated to stocks compared to high-quality bonds. This is probably why many new investors get confused about the true nature of convertible bonds.

Let’s define three types of convertibles and try to clear that common confusion away.

Vanilla Convertible Bonds

A vanilla convertible bond gives you, the investor, the choice to hold the bond until its maturity or to convert it to stock. The conversion takes place according to the predetermined conversion rate.

It’s the most common type of convertible bond.

Ideally, you would want to convert to stock when the stock’s sale gain exceeds the bond’s face value plus its remaining interest payments.

In case the stock price has decreased since the bond’s issue date, you may hold the bond until its maturity. You will then receive a payment equivalent to the bond’s face value.

If, on the other hand, the stock price increases significantly, you may convert the bond to stock, and then hold the stock or sell it at your discretion.

Mandatory Convertibles

A mandatory convertible bond is a common variation of vanilla convertibles. It’s just that the conversion, as the name suggests, is obligatory.

So, mandatory convertibles have to be converted into shares at a specified conversion ratio and a particular price level at maturity.

These convertibles would often have two conversion prices. The first price is limited such that you, the investor, would receive the bond’s par value back in shares. The second price delimits, and you will earn above the par.

If the stock price is lesser than the first conversion price, you will suffer a capital loss. 

Reverse Convertibles

A reversible convertible bond gives the discretion of conversion to the company. Reverse convertibles can be converted to equity shares or to be kept as a fixed-income investment until the bond’s maturity. Still, the conversion is done at a predetermined price and conversion ratio.

It has a structure opposite that of the vanilla set-up. The conversion ratio acts as a knock-in short put option.

What They Have Over Regular Debt Securities

Historically, the return from convertibles has been higher than the gains from other kinds of fixed-income investments. This and other benefits below make convertible bonds attractive to many investors.

Higher Yield Potential

Since a convertible bond includes the option to be converted into stock, a rise in the stock price also increases the value of the convertible.

That is to say that if the company’s stock does well, the bonds’ value will rise along with it.

In comparison, the value of traditional corporate bonds and their corresponding coupon payments at maturity won’t be affected by improvements on corporate earnings.

Limited Risk

If the company’s stock does poorly but remains solvent, investors can only fall so far since they have a maturity date. As a bondholder, you would receive no less than the par value or the face value of the bond. And in this sense, convertibles have a more limited downside compared to common stocks.

A convertible bond protects your principal on the downside while also allowing you to join in the upside as the underlying company gains success.

Take the case of a startup company. They might be working on a project that needs considerable capital, which causes the company to suffer losses in their near-term revenues. This project, however, has the potential to gain significant profits in the future.

As a convertible bond investor, you can get back a part of your principal if the company fails. If it succeeds, then you can benefit from capital appreciation. Just convert the bonds into equity, then.

Lower Interest Payments

The lower interest payments that come with convertible bonds are an advantage to the issuer rather than the investor.

But because of the bond’s higher yield potential from the conversion opportunity, investors simply accept its lower interest payments. Issuing companies can thus save on such coupon rates.

Tax Advantages

With convertible bonds, the interest payments are tax-deductible. So, they allow the issuer to save even more money from interest tax. This benefit is otherwise not possible in equity financing.

Deferral of Stock Dilution

Some companies are not willing to dilute their stock shares in the medium term, but they’re okay with stock dilution in the long run.

If they do prefer the deferral of stock dilution, it would be more helpful for companies to choose convertible bond financing over equity financing.

With convertibles, the current shareholders of the company could benefit from the capital appreciation of the company’s future stock price.

Its Limitations

While returns from convertible bonds are typically higher than other fixed-income investments, they come with more volatility.

Here are the limitations of convertible bonds.

As to Availability

Convertible bonds are not always as readily available as the common stock. Not every company will offer convertible bonds. 

Those with a low credit rating but have high growth potential are the typical companies that issue convertible bonds. 

While you might find an issuing company, the offered convertible bond may not have the features you want.

Anyhow, some investors extend their effort to look for and buy convertible bonds. Others, on the other hand, use exchange-traded funds or mutual funds to invest in convertibles. 

The diversification that these mutual funds offer can provide you with even greater safety. But that’s at the cost of being unable to choose for yourself the individual companies. I mean, those from which you’re buying the convertible bonds.

As to Conversion

If the company’s stock does poorly, you won’t be able to convert the convertible bond into shares and will only have the yield to show for it.

Moreover, if the company declares bankruptcy, investors have a lower priority to claim assets.

Vulnerability to Losses

In cases, though rare, where the issuer goes bankrupt, you’ll have a lower priority to claim to the issuing company’s assets. That’s in comparison to those who invested in non-convertible, i.e., straight debts.

So, if the issuing company defaults or fails to make payments on time, you become more vulnerable to the losses. To avoid such risks, be sure to conduct extensive research on the company you’re planning to invest in.

The Best of Both Worlds

Convertible bonds are a hybrid investment that offers both safety and potential growth. It provides protection from investment risks characteristic of traditional bonds as well as the potential of generating higher total gains, inherent to corporate stocks.

In other words, convertibles provide you security if you wish to participate in a company you’re not yet sure of. Overall, you may be limiting your upside potential when investing in convertible bonds, but you’re limiting your downside risk at the same time.

Indeed, convertible bonds have a risk-and-return profile that resembles more closely with stocks compared to most fixed-income investments. Given this stock-like characteristic, convertibles are something you would want to include in your aggressive income allocation, but not the fixed-income portion of your portfolio.