What are Convertible Bonds?
Convertible Bonds are fixed-income issuances structured with a conversion option to exchange them for a certain number of shares (i.e. equity) in the underlying company.
Convertible Bond Features: Hybrid Financing Instruments
Convertible bonds, or “convertibles,” are hybrid financing instruments that blend the traditional features of debt and equity.
Convertible bonds provide the bondholder with the option to convert the bonds into equity if certain conditions are met.
The differentiating factor of convertible bonds is their “equity-kicker”, where the bonds can be exchanged for a pre-determined number of equity shares.
Until converted, the issuer is obligated to pay interest periodically to the bondholder, who can redeem the bonds for a set time frame to receive either:
- Equity – Shares in the underlying company issuing the bonds, i.e. partial equity ownership
- Cash – Cash proceeds of equivalent value to an agreed-upon number of shares
Convertible Bonds Investing: Debt and Equity Component
The appeal of convertible bonds for bondholders is the added optionality of equity participation for equity-like returns along with bond-like protection, creating a more balanced risk/reward profile.
- Upside Potential – If the share price of the underlying issuer rises, bondholders can earn equity-like returns post-conversion via price appreciation.
- Downside Risk Mitigation – If the share price of the underlying issuer declines, bondholders can still receive a consistent stream of income through interest payments and repayment of the original principal.
The decision to convert the bonds into equity is up to the bondholder, with the main consideration being the share price of the underlying company.
Like options, bondholders usually opt to convert the bonds into common shares only if doing so results in a higher return than the yield on the bonds.
- Debt Component – The market price varies based on the prevailing interest rate environment and the borrower’s creditworthiness (i.e. perceived default risk).
- Equity Component – The share price of the underlying company is the prime consideration, which is priced based on recent operating performance, investor sentiment, and ongoing market trends, among numerous other factors.
Convertible Bonds: Lending Terms
Convertibles are issued with the key terms clearly stated within the loan agreement, as well as the details regarding the conversion option.
- Principal – The face value (FV) of the bond, i.e. the amount invested in the convertible bond offering
- Maturity Date – The maturity of the convertible bonds and range of dates on which conversion could be done, e.g. conversion only at predetermined times
- Interest Rate – The amount of interest paid on the outstanding bond, i.e. not yet converted
- Conversion Price – The share price at which conversion occurs
- Conversion Ratio – The number of shares received in exchange for each convertible bond
- Call Features – The right of the issuer to call a bond early for redemption
- Put Features – The right of the bondholder to force the issuer to repay the loan at a date earlier than originally scheduled
Conversion Ratio and Conversion Price
The conversion ratio determines the number of shares received in exchange for one bond and is established on the date of issuance.
For instance, a “3:1” ratio means the bondholder is entitled to receive three shares per bond post-conversion.
The conversion price is the price per share at which a convertible bond can be converted into common shares.