Convertible bonds are a type of corporate debt security that provide fixed-income payments like a bond, but can be converted to common shares of stock. As such, they’re often referred to as “hybrid securities.”
Most convertible bonds give investors a choice. They can hold the bond until maturity, or convert it to stock at certain times during the life of the bond. This structure protects investors if the price of the stock falls below the level when the convertible bond was issued, because the investor can choose to simply hold onto the bond and collect the interest.
Key Points
• Convertible bonds are known as hybrid securities because they offer investors some fixed-income features as well as equity features.
• Convertible bonds offer fixed-income payments, as well as the potential to be converted to a pre-set number of common stock shares in the company.
• The investor can obtain shares based on the conversion ratio, which is determined at the time of purchase.
• The conversion price per share is also built into the bond contract.
• There’s no obligation to convert these securities. When the bond matures, the investor can either take their principal, or convert it to the corresponding shares.
How Do Convertible Bonds Work?
Companies will often choose to issue convertible bonds to raise capital in order to not alienate their existing shareholders. That’s because shareholders may be uneasy when a company issues new shares, as it can drive down the price of existing shares, often through a process called stock dilution.
Convertible bonds are also attractive to issue for companies because the coupon — or interest payment — tends to be lower than for regular bonds. This can be helpful for companies who are looking to borrow money more cheaply.
What Are the Conversion Ratio and Price?
Every convertible bond has its own conversion ratio. For instance, a bond with a conversion ratio of 3:1 ratio would allow the holder of one bond to convert that security into three shares of the company’s common stock.
Every convertible bond also comes with its own conversion share price, which is set when the conversion ratio is decided. That information can be found in the bond indenture of convertible bonds.
Convertible bonds can come with a wide range of terms. For instance, with mandatory convertible bonds, investors must convert these bonds at a pre-set price conversion ratio.
There are also reverse convertible bonds, which give the company — not the investor or bondholder — the choice of when to convert the bond to equity shares, or to keep the bond in place until maturity.
But it also allows the investor to convert the bond to stock in the case where they’d make money by converting the bond to shares of stock when the share price is higher than the value of the bond, plus the remaining interest payments.
In general, these options are not available when investing online.
How Big Is the Convertible Bond Market?
As of 2024, the size of the U.S. convertible bond market was estimated to be about $270 to $280 billion. Securities have been issued by hundreds of companies. But note that these numbers are miniscule compared to the U.S. equity market, which has trillions in value and thousands of stocks.
The total size of the convertible bond market does expand and contract, though, often with the cycling of the economy. In 2024, the total convertible bond issuance reached nearly $88 billion, versus $55 billion in 2023, and $29 billion in 2022. This may reflect the higher interest-rate environment, and companies’ desire to minimize debt payments.
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Reasons to Invest in Convertible Bonds
Why have investors turned to convertible bonds? One reason is that convertible bonds can offer a degree of downside protection from the bond component during stock volatility. The companies behind convertibles are obligated to pay back the principal and interest.
Meanwhile, these securities can also offer attractive upside, since if the stock market looks like it’ll be rising, investors have the option to convert their bonds into shares. Traditionally, when stocks win big, convertibles can deliver solid returns and outpace the yields offered by the broader bond market.
For example, in 2024, the U.S. convertibles market returned 11.4%, outpacing the performance of all major fixed-income indices. And over the 10-year period ending December 31, 2024, convertible bonds have delivered a higher yield than equities, according to data by Bloomberg.
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Downsides of Convertible Bonds
One of the biggest disadvantages of convertible bonds is that they usually come with a lower interest payment than what the company would offer on an ordinary bond. As noted, the chance to save on debt service is a big reason that companies issue convertibles. So, for investors who are primarily interested in income, convertibles may not be the best fit.
There are also risks. Different companies issue convertible debt for different reasons, and they’re not always optimal for investors. Under certain conditions, convertible financing can lead to “death spiral financing.”
What Is Death Spiral Debt?
The death spiral is when convertible bonds drive the creation of an increasing number of shares of stock, which drives down the price of all the shares on the market. The death spiral tends to occur when a convertible bond allows investors to convert to a specific value paid in shares, rather than a fixed number of shares.
This can happen when a bond’s face value is lower than the convertible value in shares. That can lead to a mass conversion to stock, followed by quick sales, which drives the price down further.
Those sales, along with the dilution of the share price can, in turn, cause more bondholders to convert, given that the lower share price will grant them yet more shares at conversion.
How to Invest in Convertible Bonds
Most convertibles are sold through private placements to institutional investors, so retail or individual investors may find it difficult to buy them.
But individual investors who want to jump into the convertibles market can turn to a host of mutual funds and exchange-traded funds (ETFs) to choose from. But because convertibles, as hybrid securities, are each so individual when it comes to their pricing, yields, structure and terms, each manager approaches them differently. And it can pay to research the fund closely before investing.
For investors, one major advantage of professionally managed convertible bonds funds is that the managers of those funds know how to optimize features like embedded options, which many investors could overlook. Managers of larger funds can also trade in the convertible markets at lower costs and influence the structure and price of new deals to their advantage.
The Takeaway
Convertible bonds are debt securities that can be converted to common stock shares. These hybrid securities offer interest payments, along with the chance to convert bonds into shares of common stock.
While convertible bonds are complex instruments that may not be suitable for all investors, they can offer diversification, particularly during volatile periods in the equity market. Investors can gain exposure to convertible bonds by putting money into mutual funds or ETFs that specialize in them.
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FAQ
Why would an investor choose convertible bonds?
Convertible bonds offer downside protection for an investor’s principal, and also offer the potential to see equity gains as well.
What is the difference between a corporate bond and a convertible bond?
The main difference is that a corporate bond pays a fixed rate of interest that’s typically higher than a convertible bond coupon. But a regular corporate bond doesn’t offer access to an equity upside the way a convertible bond can.
Can a convertible bond be converted into cash?
Yes. First, in some cases a convertible bond may offer the option to convert to cash value rather than a pre-set number of company shares. Then, there is always the option to redeem the bond at maturity for its cash value.
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