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 is the relationship between the current yield and risk?

    Discover the relationship between a bond’s current yield and risk, and how investors can use it to benefit their overall ...
  2. How does the bond market react to changes in the Federal Funds Rate?

    Discover how the bond market reacts to changes in the federal funds rate. The risk-free rate of return is a major factor ...
  3. How do I use the holding period return yield to evaluate my bond portfolio?

    Find out how to use the holding period return yield formula to evaluate the performance of bonds in your portfolio, and view ...
  4. What is the relationship between current yield and yield to maturity (YTM)?

    Learn about the relationship between a bond's current yield and its yield to maturity, including how the market price of ...
RELATED TERMS
  1. Long-Term Debt

    Long-term debt consists of loans and financial obligations lasting ...
  2. Accelerated Return Note (ARN)

    A short- to medium-term debt instrument that offers a potentially ...
  3. Next Generation Fixed Income (NGFI) Manager

    A Next Generation Fixed Income (NGFI) manager is a fixed income ...
  4. Next Generation Fixed Income (NGFI)

    Next generation fixed income is an innovative approach to investing ...
  5. Class 3-6 Bonds

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

You May Also Like

Related Articles
  1. Mutual Funds & ETFs

    ETF Analysis: iShares Barclays Aggregate ...

  2. Investing

    Go Green with a Investment in Green ...

  3. Investing

    Short-Term Funds or Fixed Deposits: ...

  4. Term

    Long-Term Debt

  5. Investing Basics

    How To Create Capital Protected Investment ...

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!