A convertible bond is an investment vehicle that starts as a bond and then can turn into a stock. These bonds are often framed by sellers as a way to reduce risk by having the certainty of a bond that offers the upside of a stock’s potential value appreciation. Read on for more about convertible bonds, how they work, why they exist and when they might be good investment choices.
Understanding Convertible Bonds: Features And Mechanics
A convertible bond is a fixed-income instrument that, like any bond, is a loan. Initially, investors buy bonds from a company for a fixed price. The bond has a coupon rate stating the percentage of interest the bond holder receives until maturity. The company that sells the bonds uses the money to fund activities like expansion, financing, innovation or acquisitions.
The investor can hold a bond, receiving regular interest payments, and eventually receive the initial amount owed at the end of the bond’s term or the period of time over which the corporation selling the bond had agreed to pay interest.
As with other bonds, investors can trade bonds on secondary markets, either buying or selling. At that point, bonds are priced by market activity with prices moving inversely to interest rates. If, for example, you had a bond with a 4% rate and you wanted to sell it on a secondary market, if in general interest rates moved up to 5%, the bond would sell for less than par (the face price) because other investors could make more money overall by purchasing one of the higher-rate bonds. If interest rates dropped to 3%, the bond would be worth more than par because buying an equivalent bond would pay less interest over the term.
Where things get more complicated with convertible bonds is because they can allow the investor to swap a bond for common stock under certain conditions. This typically happens when shares hit a predetermined value in the equities markets, called the conversion price, set at the time the bond is initially sold. The conversion ratio, also set at initial sale time, specifies how many shares of stock the bond receives at conversion.
Typically, the bond holder can convert to stock shares at will after the conversion price is reached. This is where the issue of risk management enters. Investors can decide to convert and then either hold or sell the shares, depending on the financial implications, or they can continue to hold the bond.
That is the typical approach. In some cases, again known at the time of the bond’s purchase, the company might have the right to force conversion.
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Benefits And Risks Of Investing in Convertible Bonds
In theory the investor gains the certainty of return that a bond offers with the upside that if the stock does well enough, you can move your investment to the equity part and gain the benefit. Should the stock lack luster in its performance, you can hold the bond.
However, in practice, “they sound a little bit better than they really are,” says Richard Alt, chief investment officer at registered investment advisor Carnegie Investment Counsel. “It’s usually issued by a weaker corporation that doesn’t necessarily want to dilute [existing] shareholders by issuing more stock or take on more debt. Instead of having to issue debt at 12% interest, maybe they can issue it at 8% interest because they have this carrot of being converted down the road.”
More cynically, the company doesn’t want dilution of executives’ stock holdings. “It’s usually a small company, they’ve already issued stock, they’ve taken on as much debt as they can, but they need one more round of financing, so they do a convertible bound,” Alt says. That means there’s both lower interest than normal on the bond portion and greater uncertainty on the stock’s upside. “We, as a discretionary manager that manages $4 billion for individual investors for 50 years, will almost never buy a convertible bond at issue.”
“Essentially, one should think of the issuance of convertible bonds as delayed equity financing,” says Robert Johnson, a professor at the Heider College of Business of Creighton University. “That is, the firm issues bonds that are convertible into common stock at a price higher than the prevailing market stock price. The interest rate on the bonds is also lower than the firm would have to offer in the absence of the conversion right. This allows the company to lower its financing costs in the short-run.”
Lowering financing costs means getting less return on the bond side than might be the case for better quality bonds. They also mean a bet on the stock of what might be a weak company, making value appreciation chancier than with another company’s stock. Or, as Johnson says, “The perfect climate for companies to issue convertible bonds is likely the worst time for investors to buy them.”
“Someone whose primary motivation is long-term wealth accumulation should not consider convertible bonds, as the return earned on convertibles over the long run is less than that earned in simply investing in the equity markets,” says Johnson. Many investors will do better with a more appropriate choice of a traditional bond or a stock.
But don’t necessarily count all convertible bonds out.
According to Johnson, there are people who will be attracted to the instruments. “The ideal investor in convertibles are those who desire reliable current income but would also like to earn some price appreciation in the long-run,” he says. In other words, if you, by your nature, are highly risk adverse this might be a good match, allowing you to invest while feeling safer in the process.
More broadly, Alt notes, a convertible bond might make sense under the following conditions:
- The company is fundamentally sound.
- The company needs to raise money because of unusual reasons, like it looks to make an unusual significant investment that will add appropriate value to the company or has been temporarily caught during a business cycle in a way it couldn’t avoid.
- The bond rate isn’t too low compared to other bonds and the stock is likely to appreciate.
- The conversion decision is left in your hands and not something the company can force at will or on an arbitrary date.
Even if the convertible may not be the best option at issue, someone might be unloading their holdings on a secondary market at a significant discount, not unusual because the secondary trading for convertible bonds is thin (which by itself says a lot). “We would be hoping for a double-digit return” with the discount, Alt says.
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Evaluating Convertible Bond Issuers And Terms
In keeping with the above, it’s important to know whether the convertible bond issuer is a weak company with lower prospect of ultimately providing a good return or a stronger prospect caught in circumstances but that will likely return to more normal conditions.
Check the credit rating of the company. You want one that is strong and unlikely to default on its obligations, because bonds always carry some degree of risk that the issuer won’t fully pay off the loan and it’s important to minimize that risk.
The company’s financial health is also important. Look at cash flow, balance sheet, sales and profit histories, existing debt, along with other metrics. The business should be strong with the potential for value appreciation that would drive the stock price upward. If there seems little likely upside for the stock of a weaker company, it could be that management is going the convertible route as the rationale for lower coupon rates while knowing the stock probably won’t trigger a conversion opportunity.
Whatever the case, look at the coupon rate, conversion price and conversion ratio. Is there a realistic chance of a conversion happening and are you going to get enough shares to make the bond’s value reasonable? Or is the interest rate enough to be satisfied holding the bond to maturity?
Also, consider current interest rate trends. Depending on whether they are likely rising or falling, the future price of the bond might appreciate or fall.
Top Performing Convertible Bonds: Income And Growth Opportunities
“The best way for the DIY investor is to take a position in a convertible bond fund or ETF,” Johnson says. The amount of work needed to go through individual offerings is high, and there is little way to tell in advance when a company might plan an issue.
“Diversification is the biggest advantage” of ETFs, Johnson adds, “but also professional management is important in this highly-specialized area. The disadvantage is that expense ratios of these highly specialized funds tend to be rather large (from 75 to 100 basis points annually). The largest convertible exchange-traded fund is SPDR Bloomberg Barclays Convertible Securities (CWB), which yields 3.5%, has a 4-star Morningstar rating and has a relatively low expense ratio of 0.40%. The second largest convertible bond ETF is the iShares Convertible Bond ETF (ICVT), which yields 3.2%, has a 4-star Morningstar rating and has a very low expense ratio of 0.2%.”
Convertible Bonds Vs. Traditional Bonds And Equities
Although the right convertible bond, or a lesser one available at a fire sale, may offer a reasonable investment, for most people, moving into traditional bonds and equities will be a wiser choice. Rather than spending the time picking and then monitoring—constantly having to decide whether to convert or even to continue holding the bond at all—choosing some traditional bonds and stocks can give better portfolio risk management.
Convertible Bonds FAQs
How do convertible bonds work?
A convertible bond comes with a coupon interest rate, like any bond, but under specified circumstances can be converted into a predetermined number of shares should share prices reach a specified price.
What are the advantages of investing in convertible bonds?
Convertible bonds can provide some risk management in case share prices don’t grow as expected. However, often convertible bonds end up providing less return than equivalent choices of stocks and bonds would.
Are convertible bonds suitable for conservative investors?
Probably not. The ultimate return can be lower than equivalent regular bonds and stocks.
How can investors evaluate the creditworthiness of issuers of convertible bonds?
Check with firms that rate creditworthiness of public companies and of bond issuers.
Are convertible bonds affected by interest rate changes?
They are, like any bond, unless converted into shares, at which point they act like stocks.
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