What’s a Convertible Bond? A Different Mode of Investment

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.

How do convertible bonds work?

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.

How big is the market for convertible bonds?

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.)

What are some other key features of 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.”

What benefits do corporate convertible bonds offer investors?

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. 

What benefits do convertible bonds offer companies?

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.

What are the risks of investing in convertible bonds?

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.”

How do you go about investing in convertible bonds?

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.