Convertible bonds

What Are Convertible Bonds?

A convertible bond, also referred to as a convertible note, is a type of corporate debt securities with a fixed income. It provides interest payments and has the unique feature of being exchangeable for a specific quantity of common stock or equity shares. The conversion process typically occurs at specific points in the bond’s duration and is typically decided by the holder of the bond.

Because it possesses characteristics of both debt and equity, the value of a convertible bond reacts strongly to fluctuations in interest rates, the market value of the underlying stock, and the credit rating of the issuing company

Convertible securities debuted in the 19th century in the United States to secure funds for expanding the railway system. Convertible bonds have gained global availability, with a remarkable outstanding sum exceeding $400 billion. However, they continue to represent a modest fraction of the comprehensive corporate bond market. Specifically, convertible bonds account for around 2.5% of the total U.S. corporate bonds outstanding value, which stands at $8 trillion.

Among issuers, information technology companies stand as the prominent players in the convertible bonds landscape, contributing to over 30% of the outstanding issues. Moreover, approximately 60% of convertible bonds are denominated in U.S. dollars, reflecting their strong prevalence in the American market.

Convertible Bonds Explained

Convertible bonds present companies with a versatile avenue for raising funds. Such bonds constitute a hybrid financial instrument that grants investors the advantages of a bond, including interest payments, along with the potential for stock ownership. The conversion ratio of these bonds specifies the quantity of shares an individual can acquire through the conversion of a single bond. To illustrate, a ratio of 5:1 signifies that one bond can be converted into five shares of common stock.

How Convertible Bonds Work

"Convertibles capture more return on the upside than on the downside." – Michael Youngworth, CFA, Vice President, Equity Derivatives Research at Bank of America Merrill Lynch

Similar to conventional bonds, convertible bonds provide interest payments, usually semi-annually, based on the coupon rate. Upon reaching the maturity date, if the bond hasn’t been converted into common stock, the bondholder receives the bond’s par value, typically $1,000.

Certain convertible bonds may be redeemed or called back by the issuer before maturity, although the prevailing trend over the past decade leans toward convertible bonds lacking a call feature. Convertible bonds that lack a call option generally have shorter maturities than those with such a feature.

Convertibles deviate from traditional bonds due to the convertible bondholder’s prerogative to swap the bond for a predetermined quantity of common stock shares before the bond matures.

The conversion ratio specifies the quantity of common stock shares allocated to the bondholder in exchange for the bond’s par value. The bond’s prospectus outlines the conversion ratio and additional criteria that must be met for the bond-to-stock conversion to occur.

Most convertible bond offerings incorporate a provision that adjusts the conversion ratio if the company issues dividends in cash or stock, releases extra stock shares, or executes a stock split.

The increased conversion ratio serves as compensation for convertible bondholders in response to corporate events that augment the count of stock shares or exert downward pressure on the company’s stock value.

Analyzing and Pricing Convertible Bonds

Convertible bonds possess both a fixed income element and an equity aspect that encompasses the option to convert the bond into stock. The analysis of convertible bonds involves evaluating the bond and equity components separately in relation to the convertible’s market price.

1. Investment Value. The intrinsic value of a convertible bond is determined by its fixed-income attributes, considering prevalent interest rates, including the yield of the issuer’s nonconvertible bonds. This value sets a lower limit for the convertible bond’s price, which is rarely breached.

2. Investment Premium. Most convertible bonds trade above their investment value. The difference between a convertible bond’s market price and its investment value constitutes the investment premium. This premium signifies the extra worth investors attribute to the convertible bond beyond its identity as an interest-bearing fixed-income security.

3. Conversion Price. This represents the convertible bond’s value when converted into stock. It is calculated by multiplying the stock price by the conversion ratio, which specifies the shares received per bond. The conversion value establishes a minimum price for the convertible bond from an equity perspective.

4. Conversion Premium. In many cases, convertible bonds are priced higher than their conversion value. The disparity between a convertible bond’s market price and its conversion value forms the conversion premium. This premium mirrors the added value of the convertible bond as an equity-linked investment.

5. Impact of Stock Price. As the stock price climbs, the conversion value rises while the conversion premium diminishes. When the conversion value surpasses the investment value, converting the bond into stock becomes profitable. At this point, the convertible bond’s price becomes closely linked to the issuer’s stock performance.

6. Busted Converts. Convertible bonds with conversion values significantly below their investment values are termed "busted converts." These bonds have minimal investment premiums and are predominantly influenced by fixed-income attributes, reflecting skepticism about profitable stock conversion.

7. Delta. Delta gauges the convertible bond’s price sensitivity to its common stock. A convertible with a high conversion value compared to its investment value will exhibit a delta close to one, mirroring stock price fluctuations. Conversely, a low delta characterizes a convertible with a conversion value much lower than the stock price, aligning its price movements with nonconvertible bonds.

8. Market Behavior. Convertible bonds offer support through their fixed income component as stock prices decline, preventing significant drops. When interest rates rise, convertible bonds often experience smaller price declines than nonconvertible bonds due to the equity option embedded in convertibles.

Purpose of Issuing Convertible Bonds

Companies issue convertible bonds due to their lower interest rates compared to non-convertible debt. This characteristic appeals particularly to companies experiencing revenue growth but not yet achieving profitability.

In cases where a company is grappling with losses, default risk is higher, prompting bondholders to demand elevated interest rates. A company can secure debt at a reduced interest rate by employing convertible bonds. This occurs because investors benefit from the security of a senior debt instrument while also gaining the potential to partake in the company’s expansion if its stock price appreciates.

Convertible debt issuance also allows companies to bypass the time-consuming process of obtaining credit ratings for their bond offering from a credit rating agency.

Furthermore, convertible bonds grant companies the ability to amass funds without an immediate dilution of the ownership stake held by existing common stock shareholders. Dilution arises when the number of outstanding common stock shares increases, diminishing the share ownership percentage. This situation necessitates distributing total earnings and dividends among a larger share base. Without a commensurate increase in total earnings, the issuance of more stock shares could lead to a decline in earnings per share.

Upon eventual conversion, convertible bonds result in the issuance of additional shares, which can dilute the holdings of common stock shareholders.

To defer conversion, the stock price at which conversion becomes economically viable for convertible bondholders is generally set at least 20% higher than the stock price at the time of convertible bond issuance. This strategic move helps to manage the timing and impact of conversion on shareholder equity.

Types of Convertible Bonds

Several distinct kinds of convertible bonds warrant examination, including vanilla convertible bonds and mandatory convertible bonds.

A vanilla convertible bond adheres to the standard format. Investors possess the choice to either retain the bond until maturity, obtaining its nominal value, or opt for conversion into equity shares to capitalize on an upswing in the issuer’s stock value. Vanilla convertible bonds yield a relatively lower return to investors due to the inclusion of the conversion option, which is not obligatory.

A mandatory convertible bond operates as the name implies: an investor’s bonds undergo automatic conversion by a predetermined date outlined in the bond’s indenture agreement. In the case of mandatory convertibles, the investor garners a more substantial return prior to the mandatory conversion point. Post-conversion, returns may fluctuate, contingent on the issuer’s equity performance.

Advantages and Drawbacks of Convertible Bonds

The issuance of convertible bonds offers companies a means to mitigate adverse investor sentiment that typically arises from equity issuance. Whenever a company introduces more shares or equity, the total number of outstanding shares increases, diluting existing investor ownership. To sidestep this sentiment, a company might opt for convertible bonds. This allows bondholders the possibility to convert into equity shares if the company’s performance is favorable.

Convertible bond issuance also furnishes investors with a measure of security in case of default. While safeguarding investors’ principal in downturns, convertible bonds enable participation in upswings if the underlying company prospers.

For instance, a startup company may require substantial capital investment for a project that initially results in revenue loss. However, the project is projected to drive future profitability. In the event of company failure, convertible bond investors can recover some principal, while successful outcomes enable them to benefit from capital appreciation through bond conversion into equity.

Investors can capitalize on the intrinsic value embedded within convertible bonds, essentially combining a bond with a call option, which grants the right—but not obligation—to purchase a stock, bond, or other assets at a specific price during a defined period. However, convertible bonds typically yield a lower coupon rate or rate of return, given the included option to convert to common stock.

Companies profit from issuing debt at lower interest rates compared to conventional bond offerings. Nevertheless, not all companies opt for convertible bonds. Furthermore, convertible bonds are often perceived as riskier and more volatile than standard fixed-income instruments.

Advantages

1. Investors receive fixed-rate interest payments along with the opportunity to convert to stock and capitalize on stock price appreciation.

2. Investors enjoy a measure of default risk protection since bondholders are prioritized ahead of common stockholders.

3. Companies benefit from capital raising without an immediate dilution of their shares.

4. Companies can potentially secure lower interest rates on their debt compared to conventional bonds.

Drawbacks

1. Due to the bond-to-common stock conversion option, these bonds offer a reduced coupon rate.

2. Issuing companies with limited or no earnings, such as startups, introduce additional risk for convertible bond investors.

3. Conversion of bonds into stock shares can lead to share dilution, potentially impacting share prices and earnings per share dynamics.

Illustration of a Convertible Bond

Example 1

To illustrate, consider Exxon Mobil Corp. (XOM) issuing a convertible bond with a $1,000 face value, carrying a 4% interest payment. This bond matures in 10 years and has a convertible ratio of 100 shares per convertible bond.

If the bond is held until maturity, the investor receives $1,000 in principal along with $40 in annual interest. However, if the company’s shares suddenly surge, trading at $11 per share, the 100 stock shares are valued at $1,100 (100 shares x $11 share price), surpassing the bond’s value. The investor can convert the bond into stock, acquiring 100 shares, which can then be sold in the market for a total of $1,100.

Example 2

In scenarios involving convertible bonds, the issuing company typically anticipates a rise in their share price.

To illustrate, suppose a company aims to secure $10 million in funds, and the present share price stands at $25. In this case, issuing 400,000 new shares becomes necessary to meet the capital-raising objective.

$10 million = $25 x [Shares Issued] Shares Issued = 400,000

With convertible debt, the conversion can be postponed until the share price experiences an increase. For instance, assuming the company’s shares double in value, reaching $50 per share, the quantity of shares issued is halved.

$10 million = $50 x [Shares Issued] Shares Issued = 200,000

Consequently, owing to the augmented share price, the number of shares needed to achieve the target diminishes to 200,000, thereby mitigating the overall dilutive impact.