Learn about convertible bonds, what appeal they might have for investors, and how they differ from corporate bonds.
If it drives like a bond, steers like a bond, and honks like a bond … it’s probably a bond, right? With convertible bonds, the answer isn’t quite so cut-and-dried. Convertible bonds are indeed debt securities. They’re often issued by corporations, and they pay a fixed rate of return for a certain period. But these securities can also morph into a different mode of investment.
What is a convertible bond exactly? Although these securities are technically bonds, convertible bonds differ from traditional bonds and other fixed-income investments in a few key ways, says Craig Laffman, director of fixed income trading and syndicate for TD Ameritrade.
For one, corporate convertible bonds are a type of debt security that can be converted into a fixed number of shares of the issuer’s common stock. Convertible bonds can also be complex and risky. They’re often geared toward institutional investors, and mostly available to the retail crowd via funds.
What do investors need to know about convertible bonds? Let’s cover a few basics.
The company selling a convertible bond structures the security so there’s a conversion to stock at a fixed rate, or a conversion ratio, Laffman says. Conversion must occur at specified times, at specified prices, and under specified conditions.
Here’s a simplified example. Suppose a company whose stock is trading at $50 issues a $1,000 convertible bond. Investors who purchase one of those bonds gain the opportunity to buy 20 shares of the company’s stock ($1,000 divided by $50 = 20).
If the stock rises to $75, investors could convert the bond into stock and realize a gain of $25, or 50%. However, if the stock drops to $25 by the bond’s maturity, investors probably wouldn’t convert; instead, they’d let the bond mature and receive the $1,000 they initially invested, plus interest payments.
Convertible bonds are a relatively small slice of the $8 trillion-plus U.S. corporate bond market. As of mid-2018, the U.S. convertible market had a total capitalization of $223.6 billion, according to a report by Gabelli Funds. (There are several different types of convertible securities; for the purposes of this article, we’re focusing on corporate convertible bonds.)
Convertible bonds typically have lower standing compared to other forms of corporate debt (such as senior unsecured corporate bonds) and tend to have shorter maturities, Laffman says.
In addition, corporate convertible bonds are typically “callable,” meaning the company has the right, but not the obligation, to buy the bonds back from bondholders at a defined call price before the bond reaches maturity.
Why might a company call its convertible bonds? If the company’s common stock “is performing extraordinarily well, the issuer can call the bond, capping the upside appreciation of the common stock component,” Laffman says. “For investors, the upside potential is capped compared to a traditional equity investment.”
Investors in convertible bonds receive a stated interest rate over the life of the bond, and may earn a higher yield from the bond versus the dividend yield from the company’s common stock, Laffman says.
Investors also gain some level of downside protection because they’re earning interest on the initial investment, Laffman says. In other words, bondholders don’t necessarily have to convert to benefit—they can get their initial investment back at maturity, along with interest income.
There’s a best-of-both-debt-and-equity-worlds aspect to convertibles. “You’re comparing the income from the convertible bond to the dividend of the stock, but you also have the opportunity to earn upside on the stock,” Laffman says.
“You’re willing to sacrifice the extra interest you’d receive from a regular corporate bond in exchange for exposure to the underlying stock,” Laffman adds.
Convertible bonds can help companies reduce borrowing costs. A company might raise money by issuing convertibles at a 3% yield, for example, versus 5% for a traditional corporate bond, Laffman says. Companies can also gain certain tax benefits with convertibles compared to regular bonds.
But convertible bonds raise the potential for a “dilutable event” that increases the number of shares outstanding, potentially depressing the share price, Laffman notes. Convertibles are “essentially a cheaper means to borrow, if the company is willing to deal with the possibility of dilution,” he adds.
Convertible bonds can be complex and risky. Let’s look more closely at the risks. Like other fixed-income investments, convertibles have interest rate risk as well as default risk. Bonds ordinarily decline in price when interest rates rise. Because of the embedded equity component, convertibles also have market risk.
And remember: most convertible bonds are callable, so a rapidly rising stock price could result in a bond being called away. For these reasons, Laffman says, they “probably make more sense” for sophisticated investors, or investors willing to first talk to a market professional “to make sure they know the ins and outs of the security.”
Convertible bonds are not available directly through TD Ameritrade sites; clients would need to meet first with a trained Fixed Income Specialist, Laffman says.
But generally speaking, thoroughly researching the company is critical—just like when you’re considering whether to buy shares of stock, he says.“Investors should know something about the company, and they should have some comfort with how it will perform over the life of the convertible bond,” he says. “If you don’t have a positive outlook on the company, consider a traditional corporate bond.”
Investments in fixed income products are subject to liquidity (or market) risk, interest rate risk (bonds ordinarily decline in price when interest rates rise and rise in price when interest rates fall), financial (or credit) risk, inflation (or purchasing power) risk, and special tax liabilities. May be worth less than the original cost upon redemption.
Bruce Blythe is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.
for thinkMoney ®
Financial Communications Society 2016
for Ticker Tape
Content Marketing Awards 2016
Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type.
Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.
This is not an offer or solicitation in any jurisdiction where we are not authorized to do business or where such offer or solicitation would be contrary to the local laws and regulations of that jurisdiction, including, but not limited to persons residing in Australia, Canada, Hong Kong, Japan, Saudi Arabia, Singapore, UK, and the countries of the European Union.
TD Ameritrade, Inc., member FINRA/SIPC, a subsidiary of The Charles Schwab Corporation. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2021 Charles Schwab & Co. Inc. All rights reserved.