Your Practice. Popular Courses. Bonds Convertible Notes. Table of Contents Expand. What Is a Convertible Bond? Why Companies Issue Them. Conversion Ratios. Convertible Bond Downsides. Convertible Bond Numbers. The Bottom Line. Key Takeaways Convertible bonds are corporate bonds that can be exchanged for common stock in the issuing company. Companies issue convertible bonds to lower the coupon rate on debt and to delay dilution.
A bond's conversion ratio determines how many shares an investor will get for it. Companies can force conversion of the bonds if the stock price is higher than if the bond were to be redeemed. A vanilla convertible bond allows the investor to hold it until maturity or convert it to stock.
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Stocks Preferred Stocks vs. Bonds: What's the Difference? Partner Links. Hung convertibles are convertible securities with share prices trading well below the conversion price, making conversion to common stock unlikely. Fully Convertible Debenture FCD A fully convertible debenture is a debt security in which the whole value of the debenture is convertible into equity shares at the issuer's notice.
Convertible Security A convertible security is an investment that can be changed into another form, such as convertible preferred stock that converts to common stock. How Contingent Convertibles CoCos Work and the Risks Contingent convertibles CoCos are similar to traditional convertible bonds in that there is a strike price, which is the cost of the stock when the bond converts into stock.
Embedded Option An embedded option is a component of a financial security that gives the issuer or the holder the right to take a specified action in the future. Companies that may be unable to tap conventional sources of funding sometimes offer convertible securities as a way to raise money more quickly. In a conventional convertible security financing, the conversion formula is generally fixed - meaning that the convertible security converts into common stock based on a fixed price.
The convertible security financing arrangements might also include caps or other provisions to limit dilution the reduction in earnings per share and proportional ownership that occurs when, for example, holders of convertible securities convert those securities into common stock. By contrast, in less conventional convertible security financings, the conversion ratio may be based on fluctuating market prices to determine the number of shares of common stock to be issued on conversion.
A market price based conversion formula protects the holders of the convertibles against price declines, while subjecting both the company and the holders of its common stock to certain risks. Because a market price based conversion formula can lead to dramatic stock price reductions and corresponding negative effects on both the company and its shareholders, convertible security financings with market price based conversion ratios have colloquially been called "floorless", "toxic," "death spiral," and "ratchet" convertibles.
Both investors and companies should understand that market price based convertible security deals can affect the company and possibly lower the value of its securities. Here's how these deals tend to work and the risks they pose:. Before you decide to invest in a company, you should find out what types of financings the company has engaged in - including convertible security deals - and make sure that you understand the effects those financings might have on the company and the value of its securities.
Even if the company sells convertible securities in a private, unregistered transaction or "private placement" , the company and the purchaser normally agree that the company will register the underlying common stock for the purchaser's resale prior to conversion. You'll also find disclosures about these and other financings in the company's annual and quarterly reports on Forms K and Q, respectively, and in any interim reports on Form 8-K that announce the financing transaction.
If the company has engaged in convertible security financings, be sure to ascertain the nature of the convertible financing arrangement - fixed versus market price based conversion ratios.
Be sure you fully understand the terms of the convertible security financing arrangement, including the circumstances of its issuance and how the conversion formula works. You should also understand the risks and the possible effects on the company and its outstanding securities arising from the below market price conversions and potentially significant additional share issuances and sales, including dilution to shareholders.
Review the bond contract, check the credit ratings and dig deeply into the business before you make any decisions. Alternatively, there are many investment firms that offer mutual funds and exchange-traded funds ETFs that invest in convertible bonds. There are options that suit almost any investor. However, bear in mind that these funds tend to be correlated with stock market performance and may resemble equity funds, albeit with higher dividend potential.
Buying convertible bonds can be a complex affair. However, if you have strong convictions about particular companies, a convertible bond can let you pursue upside potential, albeit on a limited basis, while protecting yourself on the downside. As always, speak to a financial advisor to learn more about how convertible bonds can fit into your investment portfolio.
Rebecca Baldridge, CFA, is an investment professional and financial writer with over twenty years of experience in the financial services industry. She is a founding partner in Quartet Communications, a financial communications and content creation firm.
With two decades of business and finance journalism experience, Ben has covered breaking market news, written on equity markets for Investopedia, and edited personal finance content for Bankrate and LendingTree. Select Region. United States. United Kingdom. Rebecca Baldridge, Benjamin Curry. Contributor, Editor. Editorial Note: Forbes Advisor may earn a commission on sales made from partner links on this page, but that doesn't affect our editors' opinions or evaluations.
How Do Convertible Bonds Work? Convertible Bond vs Preferred Stock Convertible bonds are hybrid securities, meaning that they offer some of the characteristics of both fixed income and equity investments. Advantages of Convertible Bonds Companies reduce interest expenses due to lower interest rates. Companies avoid dilutive share issues.
Investors enjoy a guaranteed income stream. Downside is limited because the investor can recoup their original investment when the bond matures. Convertible bonds can add value within a diversified portfolio by reducing risk while maintaining expected return.
Convertibles offer greater potential for appreciation than ordinary corporate bonds and the investor can convert to benefit from stock price gains. In a fixed income portfolio, convertibles can enhance returns through exposure to equity-driven price increases and reduce impact of rising interest rates.
In an equity portfolio, convertible bonds can help reduce downside risk without foregoing all upside potential. Pre-conversion, investors have some protection against default since bondholders are paid before stockholders. Disadvantages of Convertible Bonds Convertible bonds are callable, meaning that the issuer can force investors to convert. A bond may be issued with a specified call date or the company may call the bond and force conversion if the stock price rises beyond a particular point.
Therefore, the upside potential of the investment may be limited. Convertible bonds are highly correlated to equity markets, meaning their values may be more associated with movements in the stock market than other types of bonds. Convertibles are sensitive to rising interest rates, although to a lesser degree than plain old corporate bonds.
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