A:

Conventional convertible bonds give the bondholder the right to exchange the bond for a certain amount of the issuer's common shares, regardless of the current market price of those shares. The bondholder will see a large payoff in situations where the total value of the underlying common shares appreciate far beyond the value of the bond. For example, ABC Corp.'s convertible bond is worth $1,000 and can be converted into 20 common shares. A bondholder would convert the bond when the share price exceeds $50 ($1,000/20). In some ways, convertible bonds have a payoff that is similar to that of holding a call option.

Death spiral convertible bonds differ from normal convertible bonds in the sense that instead of having a predetermined, fixed conversion ratio, death spirals have a floating conversion ratio in which the holder receives a discount for converting shares. For example, a death spiral bond with a face value of $1,000 has a convertible value of $1,500, which means that a bondholder will receive $1,500 dollars worth of equity for giving up a $1,000 bond.

The problem with this class of convertible security is that these bonds promote large drops in share price. This is because once a bondholder converts the bond into shares, the influx of these new shares dilutes the share price. Furthermore, bondholders have a large incentive to short sell the common stock prior to conversion, knowing that the share price will fall after the conversion is made. The short sale causes another drop in share price, giving this security its 'death spiral' name.

Interestingly enough, death spiral convertibles were a common form of financing for companies that were badly in need of cash and had little means of raising it. These companies felt that the prospect of borrowing money without paying it back outweighed the losses incurred by decreased share values.

For further reading, check out Convertible Bonds: An Introduction.

RELATED FAQS
  1. What is a 'busted' convertible bond?

    Learn about busted convertible bonds; these are hybrid securities with conversion prices significantly higher than the market ... Read Answer >>
  2. Do convertible bonds have voting rights?

    Convertible bonds usually have no voting rights until they are converted. Even after conversion, they may not be granted ... Read Answer >>
  3. How is convertible bond valuation different than traditional bond valuation?

    Read about bond valuation, particularly the differences between how a traditional bond is valued and how a convertible bond ... Read Answer >>
  4. What is a Chinese hedge?

    A Chinese Hedge is a form of arbitrage by which an investor shorts a convertible bond and buys the underlying common stock. ... Read Answer >>
  5. Why do some investors prefer convertible over “straight” bonds?

  6. What are the risks of investing in a bond?

    The most well-known risk in the bond market is interest rate risk - the risk that bond prices will fall as interest rates ... Read Answer >>
Related Articles
  1. Bonds & Fixed Income

    Convertible Bonds: An Introduction

    Find out about the nuts and bolts, pros and cons of investing in bonds.
  2. Financial Advisors

    Worried About Stocks? Try on Convertibles

    Convertibles are a good hedge against equity market risk (if you're o.k. with losing a bit of upside potential).
  3. Bonds & Fixed Income

    Convertible Bonds: Pros And Cons For Companies And Investors

    Find out why businesses choose this type of financing and what effect this has on investors.
  4. Bonds & Fixed Income

    Leverage Your Returns With A Convertible Hedge

    Find out how you can maintain your income stream by using this type of bond strategy.
  5. Stock Analysis

    The Convertible Way To Play This Market

    Investors are certainly facing a quandary. The broad market has gone up by leaps and bounds since the end of the recession. That’s worrisome. Yet, more gains could be in store as the Fed isn’t ...
  6. Options & Futures

    The Mandatory Convertible: A "Must Have" For Your Portfolio?

    Mandatory convertibles are a little understood security with some distinct advantages. Find out if they are right for you.
  7. Bonds & Fixed Income

    A Guide to High Yield Corporate Bonds

    The universe of corporate high yield bonds encompasses multiple different types and structures.
  8. Stock Analysis

    Playing Convertibles With Calamos

    Boutique firm Calamos is a specialist in convertible bonds; find out where you can get involved.
  9. Stock Analysis

    Convertible Securities On The Right Track

    For those who need income but don’t want to miss out on moves in the overall market.
  10. Mutual Funds & ETFs

    3 Convertible Bond Mutual Funds to Avoid in 2016 (CALBX, DAAIX)

    Learn about three convertible bond mutual funds with poor fundamentals and weak track records. Also learn the reasons investors why should avoid them.
RELATED TERMS
  1. Deferred Equity

    A type of security, such as preferred shares or convertible bonds, ...
  2. Conversion Value

    The financial worth of the securities obtained by exchanging ...
  3. Market Conversion Price

    An investor's effective cost to purchase common stock when it ...
  4. Convertible Bond Arbitrage

    An arbitrage strategy that aims to capitalize on mispricing between ...
  5. Conversion

    The exchange of a convertible type of asset into another type ...
  6. Convertible Hedge

    A trading strategy that consists of a long position in a company's ...
Hot Definitions
  1. Demand Curve

    The demand curve is a graphical representation of the relationship between the price of a good or service and the quantity ...
  2. Goldilocks Economy

    An economy that is not so hot that it causes inflation, and not so cold that it causes a recession. This term is used to ...
  3. White Squire

    Very similar to a "white knight", but instead of purchasing a majority interest, the squire purchases a lesser interest in ...
  4. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  5. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  6. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
Trading Center