Example
Say an investor were to purchase a convertible bond with a face value of $1,000 and a coupon rate of 2%. As long as the investor holds the bond, they’ll receive a coupon payment of $20 annually, or $10 semi-annually. The investor, while guaranteed a modest stream of income, is likely to have purchased the bond not for the interest payments but for a potential rise in the issuer’s equity share price.
Imagine that, at the same time, the investor is also able to convert the bond to equity shares at a conversion price of $15. This implies a conversion ratio of 66.67 ($1,000/$15). In other words, if the investor chooses to convert the bond to equity shares, they’d receive 66 shares (plus a fraction) in exchange.
It will only make sense for the investor to convert the bond to stock shares if the market price of the issuer’s equity exceeds the conversion price. If the price is less than the conversion price, converting the bond will result in a loss; above the conversion price, the investor will see unrealized profit. Unless the bond is a mandatory convertible bond, there is no guarantee that the investor will ever convert the bond.
The bottom line on convertible bonds
Convertible bonds are unique securities that can play a role in an investor’s diversified portfolio. Convertibles are usually appealing to investors who are willing to accept lower returns in the short run in the hope of striking it big down the line. From a company’s perspective, convertible bond issuances are a way of lowering its cost of debt in a tax-efficient manner.
As with any investment, there is a risk of loss with convertible bonds. Before investing, be sure to understand what you’re signing up for, and realize that losses are possible. If the risks are worth the rewards in your scenario, convertible bonds might be worth a second look.
