Financial Tidbits: Convertible Bonds

This week, we explore a special type of bonds in the capital markets – convertible bonds.

A convertible bond is a fixed income corporate debt security that yields interest payments while providing investors a right or an obligation to convert the bond into a predetermined number of common stock or equity shares at certain times of a bond’s lifetime.

Also, a convertible bond has features of a bond, such as maturity date and interest payments while also having the option to own the underlying stock during the bond tenure. Usually, two scenarios will pan out for a convertible bond holder:

1. Bond holder does not to convert their bonds to equity and instead holds the bond will maturity – they will receive the bond’s face value at the maturity
2. Bond holder decides to convert the bonds to company shares, the bond will lose all its debt features and only possess equity features

Other features of a convertible that are different from a traditional vanilla bond would be:

1. Conversion ratio: determines how many shares of stock you can get from converting one bond (e.g. 5:1 ratio means one bond would convert to five shares of common stock)
2. Conversion price: price per share at which a convertible security (bond or preferred share) can be converted into common stock
3. Optional callable feature: sometimes convertible bonds are callable, where issuer can buy their bonds back and therefore cap the investors’ gain to have less upside than common stock

There are three main types of convertible bonds:

1. Vanilla convertible bonds: 
   1. Most common type of bonds where bond holder has the option whether to hold the bond until maturity or convert it to stock
   2. Pays coupon payments during the life of the bond, comes with a fixed maturity date at which the investors are entitled to the principal amount of the bond
   3. Usually when the stock price decreases, investors hold the bond till maturity and get paid the face value. Whereas when stock price increases, investors can convert the bond to stock and either hold or sell the stock. Ideally, the investors will sell the stock when gain from stock sale is beyond face value of the original bond.
2. Mandatory convertible bonds: 
   1. Bonds that require investors to convert them into shares at a particular conversion ratio and price level
   2. Usually has 2 conversion prices: 
      1. To delimit the price at which an investor will receive the equivalent of its par value in shares
      2. To set a limit to the price that investor can receive above the par value
3. Reversible convertible bonds: 
   1. Bonds that give issuers the right to convert the bond to equity shares or keep the bond as fixed income investment until maturity

With the convertible feature, this bond allows the investor to enjoy the security of a bond while having the potential to reap capital gains when the company does well and share price increases. As convertible bonds are already compensating investor risks with a right to future equities, coupon payments are generally lower than traditional bonds. 

At this point, you may be thinking, “Hey, this is such a safe investment tool, let me go and buy some immediately!”. But before you do that, however, one should note that convertible bonds are generally used by companies with low credit rating or startup companies who aim to compensate and balance risk levels for their investors, rather than companies that are already doing well and have good credit ratings. Hence, convertible bonds might not be as safe as it sounds because default risk of these companies are generally higher!

With that, we hope that you learnt more about this special type of bond. Stay tuned for more financial tidbits in the following weeks!