What Is Convertible?
A convertible, most commonly known as a convertible bond, is a type of hybrid security that combines features of both debt and equity. Specifically, it is a bond that the holder can exchange for a predetermined number of shares of the issuing company's common stock or cash of equal value. This conversion feature gives investors the potential to participate in the upside of the company's stock price while still providing the downside protection and regular interest rate payments characteristic of a bond. As a fixed income instrument with an embedded equity option, the convertible offers a balance of stability and growth potential.
History and Origin
The concept of convertible securities dates back centuries, with the first recorded convertible bond issued by the Bank of Bruges in 1795. However, their prominence grew significantly in the mid-19th century, particularly with American railroad companies. These early industrial innovators utilized convertibles to attract capital, especially when conventional financing methods were challenging or less appealing.14,13 In the Netherlands, for instance, convertible bonds were first adopted in the second half of the nineteenth century by firms that faced rationing by financial markets for traditional equity and bond issues, yet were still able to successfully place convertible bonds.12 Over time, the convertible evolved from a niche financing tool into a sophisticated instrument widely used by companies across various industries to manage their capital structure.
Key Takeaways
- A convertible is a hybrid security, typically a bond, that can be exchanged for a predetermined number of shares of the issuing company's common stock.
- It offers investors the safety of fixed income payments while providing the potential for capital appreciation if the underlying stock performs well.
- Companies often issue convertibles to secure lower coupon rates compared to traditional bonds and to delay immediate dilution of existing shareholder equity.
- The value of a convertible is influenced by both interest rates and the price of the underlying stock.
- Convertibles can introduce complexities for both issuers and investors, including potential for forced conversion and a cap on upside returns.
Formula and Calculation
Several key metrics are used when evaluating a convertible:
Conversion Ratio: The number of shares of common stock an investor receives upon converting one bond.
Conversion Price: The price per share at which the bond can be converted into stock.
Conversion Value (or Stock Value): The current market value of the shares an investor would receive if they converted the bond.
Conversion Premium: The amount by which the convertible bond's market price exceeds its conversion value, often expressed as a percentage. This represents the additional cost an investor pays for the bond's income stream and downside protection.
The par value and current stock price are critical inputs for these calculations.
Interpreting the Convertible
Interpreting a convertible involves understanding its dual nature. When the underlying stock price is low, a convertible tends to behave more like a traditional bond, with its value primarily driven by prevailing interest rates and the issuer's creditworthiness. In this scenario, the regular coupon payments and the repayment of principal at maturity provide a safety net, making it an appealing option for investors seeking a steady yield.
However, as the underlying stock price rises, the equity component of the convertible becomes more valuable. If the stock price exceeds the conversion price, the convertible trades more like the underlying common stock, and its price will largely track the equity's movements. This transition highlights the convertible's unique ability to offer participation in equity upside while retaining a degree of fixed-income stability. Investors evaluate the conversion premium to determine how much they are paying for this flexibility and downside protection.
Hypothetical Example
Consider XYZ Corp., a technology startup, that issues a convertible bond with a par value of $1,000, a coupon rate of 3%, and a conversion ratio of 20. This means each $1,000 bond can be converted into 20 shares of XYZ Corp.'s common stock.
- Initial Conversion Price: The initial conversion price is ( \frac{$1,000}{20 \text{ shares}} = $50 \text{ per share} ).
- Scenario 1: Stock Price Rises. One year later, XYZ Corp.'s stock performs exceptionally well, and its share price rises to $70.
- The conversion value of the bond would be ( 20 \text{ shares} \times $70/\text{share} = $1,400 ).
- In this case, the investor can convert their bond into shares worth $1,400, realizing a gain from the equity appreciation in addition to the interest received.
- Scenario 2: Stock Price Stagnates. Alternatively, if XYZ Corp.'s stock price remains at $30 per share.
- The conversion value would be ( 20 \text{ shares} \times $30/\text{share} = $600 ).
- Since the conversion value ($600) is less than the bond's par value ($1,000), the investor would likely choose not to convert. They would continue to receive the 3% coupon payments and would be repaid the $1,000 principal at maturity, demonstrating the bond's downside protection.
This example illustrates how a convertible provides both participation in stock price increases and principal protection against declines.
Practical Applications
Convertible securities serve various purposes for both issuing companies and investors across different market conditions.
For companies, issuing convertibles can be an attractive way to raise capital. They typically allow the issuer to offer a lower coupon rate than a comparable non-convertible bond, as investors are willing to accept a reduced interest payment in exchange for the potential for equity upside. This results in lower borrowing costs and can be particularly beneficial for growth companies or those with weaker credit ratings., Furthermore, convertibles offer a delayed dilution of common stock, as shares are only issued upon conversion, rather than immediately as with a direct stock offering., This method is also often quicker for companies to bring to market compared to other forms of financing.11
From an investor's perspective, convertibles offer a unique risk-reward profile. They provide a fixed income stream and principal protection, similar to a traditional bond, while also providing exposure to potential capital appreciation if the underlying stock performs well.10, This makes them appealing for portfolio diversification and can be especially attractive in volatile markets where investors seek both security and growth potential.9 The global convertible bond market saw significant issuance in 2023, totaling around $90 billion, with the trend continuing upward into 2024.8
Limitations and Criticisms
While convertibles offer unique benefits, they also come with specific limitations and risks for investors. One significant drawback is that the upside potential of a convertible may be capped. Many convertible bonds include a "call provision" that allows the issuing company to force conversion if the stock price reaches a certain level.7 This can limit the investor's ability to fully benefit from extreme increases in the stock price, as they are forced to convert and may miss out on further appreciation as a bondholder.6,5
Another risk is that if the underlying stock underperforms significantly and never reaches the conversion price, the investor is left holding a bond that typically offers a lower yield than a comparable non-convertible bond, as they initially accepted a lower coupon in anticipation of equity upside. In such a scenario, the embedded conversion option becomes worthless, and the investor earns a subpar return relative to a straight bond. Additionally, convertible bonds are more susceptible to price depreciation than traditional corporate bonds due to their strong correlation with the underlying equity.4 Issuers of convertibles often have smaller market capitalization and weaker credit ratings than issuers of traditional corporate bonds, introducing higher credit risk.3,
These factors underscore the need for careful evaluation of both the bond and equity characteristics, as well as the issuer's financial health, when considering an investment in a convertible. Risks associated with convertible bonds include default risk and interest rate risk, in addition to market risk.2,1
Convertible vs. Warrant
A convertible (typically a convertible bond) and a warrant are both financial instruments that provide the holder with the right to acquire shares of a company's stock, but they differ fundamentally in their structure and initial nature.
| Feature | Convertible | Warrant |
|---|---|---|
| Initial Form | Debt instrument (e.g., bond or preferred stock) | Equity derivative, typically issued with other securities (e.g., bond or stock offering) or as a standalone security |
| Income Stream | Pays regular interest payments (for bonds) or dividends (for preferred stock) | Generally does not pay income; pure equity option |
| Downside Protection | Offers principal repayment at maturity if not converted, providing a bond floor | Offers no principal protection; value can drop to zero |
| Issuer Perspective | Can lower borrowing costs, delays dilution | Raises capital directly for the equity option, immediate equity instrument |
| Expiration | Converts at holder's option up to maturity (or can be called) | Has a specific expiration date, after which it becomes worthless |
The primary confusion between the two arises because both grant the right to acquire equity. However, a convertible is initially a debt or preferred equity instrument, offering an income stream and capital preservation features. A warrant, conversely, is purely an equity-linked instrument, akin to a long-term call option, offering no principal protection or income. This distinction impacts their risk-reward profiles and their roles within a company's capital structure and an investor's portfolio.
FAQs
What is the main reason a company would issue a convertible?
Companies issue convertibles primarily to secure capital at a lower borrowing cost than traditional bonds because the conversion feature makes them attractive to investors, who accept a lower interest rate in exchange for potential equity upside. It also allows companies to delay the dilution of existing common stock until conversion occurs.
Are convertibles considered bonds or stocks?
Convertibles are considered hybrid securities that possess characteristics of both bonds and stocks. Initially, they function as debt instruments, providing fixed income payments. However, they carry an embedded option that allows conversion into shares of common stock, enabling participation in equity growth.
What happens if the stock price never reaches the conversion price?
If the stock price of the issuing company never reaches the conversion price before the convertible's maturity date, the investor would likely choose not to convert. In this scenario, the convertible behaves solely as a bond, and the investor receives the regular coupon payments and the principal amount at maturity. However, the initial yield might be lower than a comparable non-convertible bond because of the initially embedded conversion feature.