A convertible bond is a debt security, issued by a corporation that gives its owner the right to acquire another security (usually the issuer's common stock directly from the issuer) in exchange for the security. The exchange terms are detailed in the bond indenture. The conversion feature results in the bondholder receiving lower yields as compared to non-convertible securities.
Typically, convertible bonds will be classified as subordinated debt, debt which is junior in ranking to senior or unsubordinated debt as far as principal repayment in the event of issuer distress or bankruptcy.
The formula for the conversion ratio is ordinarily: Par Value of Convertible Security (usually 1.00) divided by Conversion Price.
Conversion Price - Price paid per share to acquire the common stock of the issuer
Conversion Ratio - This ratio determines the number of shares the bondholder will receive per bond they exchange.
Parity - Conversion parity is the point at which neither a profit, nor loss, would be made at conversion. Basically, parity exists when the conversion ratio at issuance is equal to the convertible security price divided by the market value of the stock.
When the price of the stock increases above the conversion parity price, the convertible security would be subject to price changes relative to the movements of the stock. Any stock price appreciation thereafter will be reflected in the price of the bond allowing the bondholder to sell the convertible security for a profit rather than performing a conversion and then selling the stock for a gain.
Conversion Premium - The conversion premium measures the spread between the conversion price and the current market value of the convertible bond, and is ordinarily expressed in percent. For example, if a stock is currently trading at $50 per share and the bond conversion price is $60, the bond would be said to be trading with a 20% conversion premium.
The conversion feature offers upside to the bondholder and therefore gives the issuer the ability to achieve lower fixed costs for borrowing. Issuing debt with an conversion premium above market values is often preferable for an issuer to paying a higher cost of capital for fixed senior debt or to issuing equity at or below market values (which would also dilute equity holders).
Issuers can also impose other conditions that make these bonds more attractive as a source of capital (and potentially less so for investors). One thing that can be done is to add a call feature into the bond allowing it to be called if, for example, the company starts to increase earnings. The call feature allows the issuer to force the bondholder to convert the bonds at a lower price. It is therefore important to read bond indentures carefully before purchasing convertible bonds.
One key disadvantage to the issuer of a convertible is if the stock price increases rapidly after issuance, causing the conversion to take place in a relatively short amount of time. This indicates that the company did not do a good job of valuing itself. A second, and more negative scenario exists when the common stock actually moves lower after issuance. In this case, the bondholder will not convert to equity as the issuer had hoped, but will continue to realize interest and recover their principal.
Convertible bonds are a safer investment than buying common stock but can provide stock-like returns. They are less volatile than stocks and their value can only fall to a price where the yield would be equal to that of a non-convertible bond of the same term. They offer strong downside protection in a bear market while allowing the investor to take part in the profits as a stock moves higher.
Convertibles can be disadvantageous bondholders receive substantially lower yield to maturity in comparison to the non-convertible equivalent. This is only a concern when the issuer's equity does not achieve the upward price projections that would make taking the lower yield speculation worthwhile.
Additionally, the ability for speculation is greatly reduced when a call provision is attached to the convertible bond. This limits the upside and will force the bondholder to give up their bond at a discount to market.
Convertible bonds provide the investor with a vehicle that has lower risk and lower yields than an equivalent credit which is not convertible, yet allows the investor to take advantage of a higher stock price. The bondholder is making a tradeoff; lower yields upfront for anticipated gains in the stock price. If those gains are not achieved, the bondholder will have given up the yield spread between the convertible and non-convertible security.
Make sure you assess the credit quality of the company you are loaning money to. Does the company have the strength to withstand economic downturns or even recessions? What is the growth potential of the stock and is it enough to compensate you for the lower yield on the convertible bond?