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.

RELATED FAQS

  1. What determines the price of a bond in the open market?

    Learn more about some of the factors that influence the valuation of bonds on the open market, and why bond prices and yields ...
  2. Why should I keep records on my tax-exempt bond transactions?

    Keep your purchase records on all investments, including tax-exempt bonds. Though the interest is tax-free, you may owe taxes ...
  3. How long will it take for a bond to reach its face value?

    Learn when different savings bonds reach face value, and determine the best time to cash them in to get the highest return ...
  4. How long can I hold my HH/H Bonds and still earn interest?

    Take advantage of your bond investment and learn how long you can hold on to your Series H/HH Bonds and still earn interest ...
RELATED TERMS
  1. Class 3-6 Bonds

    Several classes of noninvestment grade bonds held by an insurance ...
  2. Impact investing

  3. Promotional CD rate (Bonus CD rate)

    A limited-time offer of a higher rate of return on a certificate ...
  4. Direct Bidder

    An entity that purchases Treasury securities at auction for a ...
  5. Indirect Bidder

    An entity that purchases Treasury securities at auction through ...
  6. Bid Wanted

    An announcement by an investor who holds a security that he or ...

You May Also Like

Related Articles
  1. Promising high yields that the Eurozone and U.S. can't match, West African sovereign debt has caught the attention of savvy investors.
    Bonds & Fixed Income

    Interested In West African Debt? Look ...

  2. Pimco has stabilized its Total Return fund, but its returns are still shaky and its sales load is still a fat one.
    Professionals

    A Look At Pimco's Total Return Fund ...

  3. With the addition of 'Bond King' Bill Gross, Janus is a changed firm. Here's what its fund lineup looks like now.
    Investing Basics

    How Does Janus's Fund Lineup Look Now?

  4. Blackrock has lowered its fees to snag money leaving Pimco's bond funds. But by how much and who's following suit? Read on.
    Investing Basics

    Thank You, Pimco: BlackRock Drops Bond-Fund ...

  5. What is the difference between corporate bonds and preferred stock? The following are a list of pros and cons for each investment.
    Trading Strategies

    Preferred Stocks versus Bonds: How to ...

Trading Center