What is the difference between convertible and reverse convertible bonds?

By Rob Renaud AAA
A:

The difference between a regular convertible bond and a reverse convertible bond is the options attached to the bond. While a convertible bond gives the bondholder the right to convert the asset to equity, a reverse convertible bond gives the issuer the right to convert to equity.

To review, convertible bonds give bondholders the right to convert their bonds into another form of debt or equity at a later date, at a predetermined price and for a set number of shares. Convertible bondholders are not obligated to convert their bonds to equity, but they may do so if they choose. The conversion feature is analogous to a call option that has been attached to the bond. If the equity or debt underlying the conversion feature increases in market price, convertible bonds tend to trade at a premium. If the underlying debt or equity decreases in price, the conversion feature will lose value. But even if the convertible option comes to be of little value, the convertible holder still holds a bond that will typically pay coupons and the face value at maturity. The yield on this type of bond is lower than a similar bond without the convertible option because this option gives the bondholder additional upside.

Reverse convertible bonds are a similar vehicle to convertible bonds as both contain embedded derivatives. In the case of reverse convertible bonds, the embedded option is a put option that is held by the bond's issuer on a company's shares. These investments give the issuer the right, but not the obligation, to convert the bond's principal into shares of equity at a set date. This option is exercised if the shares underlying the option have fallen below a set price, in which case the bondholders will receive the equity rather than the principal and any additional coupons. The yield on this type of bond is higher than a similar bond without the reverse option.

An example of a reverse convertible bond is a bond issued by a bank on the bank's own debt with a built-in put option on the shares of, say, a blue chip company. The bond may have a stated yield of 10-20%, but if the shares in the blue chip company decrease substantially in value, the bank holds the right to issue the blue chip shares to the bondholder, instead of paying cash at the bond's maturity.

To learn more about convertible bonds, see Convertible Bonds: An Introduction.

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