Convertible bonds are a form of corporate debt that also offers the opportunity to own the company’s stock. Like regular bonds, they offer regular interest payments. But they also allow investors to convert the bonds into stock according to a fixed ratio. 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. 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.
But it also allows the investor to convert the bond to stock when 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.
Here are some basics about the convertible bond market.
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 often react badly when a company issues new shares, as it can drive down the price of existing shares.
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Convertible bonds are also attractive to issue for companies because the coupon–or interest payments–on them tend to be lower than for regular bonds. This can be helpful for companies who are looking to borrow money more cheaply.
Every convertible bond has its own conversion ratio. For instance, a bond with a conversion ratio of 5:1 ratio would allow the holder of one bond to convert that security into five shares of the company’s common stock.
Every convertible bond also comes with its own conversion 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.
How Big Is the Convertible Bond Market?
In November 2020, the size of the global convertible bond market was estimated to be about $450 billion. Securities have been issued by 750 companies, according to data from Oak Tree Capital, an asset management firm that specializes in alternative investments. That’s miniscule compared to the U.S. equity market, which is valued at $49 trillion and has more than 6,000 stocks.
Global convertible issuance since the start of the Covid-19 pandemic has been on a tear, as cash-strapped companies sought cheap ways to borrow money. During 2020, issuance of convertible securities reached a record $190 billion, a 51% jump from the $126 billion raised in 2019, business publications reported. Many of the companies were from the travel, leisure and retail industries.
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However, even as economic activity perked up in 2021, the trend continued, with companies issuing nearly $20 billion in the first seven weeks of the year, the biggest amount for that period in three years.
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, they 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. History has shown that when stocks win big, convertibles can deliver solid returns and outpace the yields offered by the broader bond market. However, when stocks retreat, convertibles tend to deliver short-term losses.
In 2020, the U.S. convertibles market returned a blockbuster 43%, making it one of the top performing global asset classes as the stock market rebounded from the wild swings it experienced earlier in the year due to the Covid-19 pandemic. The convertibles market also did well in 2009, just as the global economy was recovering from the financial crisis, when it returned 49%.
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. And 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 good. Convertible financing is sometimes labeled “death spiral financing.”
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 allows buyers with a large premium to convert into shares at a fixed conversion ratio in which the buyer has a large premium.
This can happen when a bond’s face value is lower than the convertible value. 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. Being one of the shareholders who makes something out of such a catastrophe can be a matter of close study and good timing.
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 convertibles markets at lower costs and influence the structure and price of new deals to their advantage.
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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 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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