Then you have to weigh in the factors affecting their price. These factors are a mixture of what is happening in the interest-rate climate, which affects bond pricing, and the market for the underlying stock, which affects the price of the stock. Then there's the fact that these bonds can be called by the issuer at a certain price that insulates the issuer from any dramatic spike in the share price.
All of these factors are important when pricing convertibles. However, there is usually a cap on the amount the stock can appreciate through the issuer's callable provision. This means while convertible bonds limit the risk if the stock price plummets, they also limit exposure to upside price movement if the common stock soars. Getting caught up in all the details and intricacies of convertible bonds can make them appear more complex than they really are.
At their most basic, convertibles provide a sort of security blanket for investors wishing to participate in the growth of a particular company they're unsure of, and by investing in convertibles, you are limiting your downside risk at the expense of limiting your upside potential. Securities and Exchange Commission. Convertible Notes. Corporate Bonds. Your Privacy Rights.
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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. Investors accept the lower interest payments because the conversion option offers the opportunity to benefit from increases in the stock price. Companies may also choose to issue a convertible bond to manage investor sentiment.
When a company raises money through a stock offering, it issues new shares to be sold to investors. The total number of shares outstanding is increased, and existing shareholders will see their percentage of ownership decline—this is called dilution.
Dilutive share issues can also have a negative impact on stock price as shareholders may become upset their stock is now worth less and liquidate their holdings. Issuing convertible bonds, then, allows companies to raise funds without immediately diminishing value for existing shareholders.
There are several ways to invest in convertible bonds. If you want to buy individual bonds, you can do so through a brokerage with a bond desk and a specialist in convertibles. If you want to invest directly, be sure to do your research. 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. 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. You should be aware of the risks arising from the effects of the purchasers and other parties trading strategies, such as short selling activities, on the market price for the company's securities, which may affect the amount of shares issued on future conversions.
Companies should also understand the terms and risks of convertible security arrangements so that they can appropriately evaluate the issues that arise. Companies entering into these types of convertible securities transactions should understand fully the effects that the market price based conversion ratio may have on the company and the market for its securities.
Companies should also consider the effect that significant share issuances and below market conversions have on a company's ability to obtain other financing. Companies or investors seeking to learn more about the SEC's registration requirements for common stock issuable upon conversion of unregistered convertible securities, including the timing of the filing of the resale registration statement and the appropriate form that the company may use to register the resale, should consult the Division of Corporation Finance's Compliance and Disclosure Interpretations.
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