What are 'death spiral' convertible bonds?

By Albert Phung AAA
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. How does preferred stock differ from company issued bonds?

    Discover the primary differences between preferred stock and corporate bonds, two income-generating investment vehicles issued ...
  2. What's the difference between r-squared and correlation?

    Discover how R-squared calculations determine the practical usefulness of beta and alpha correlations between individual ...
  3. What is the difference between yield to maturity and the yield to call?

    Determining various the various yields that callable bonds can provide investors is an important factor in the bond purchasing ...
  4. What is the difference between the yield of stock and the yield of a bond?

    Explore and understand the various meanings of the investment term "yield" as it is applied to equity investments and bond ...
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. Stock Analysis

    Time to Look at PIMCO's Total Return ...

  2. Investing

    Will 2015 Finally Be The Year For Rising ...

  3. Stock Analysis

    Government Bond ETFs: Pros and Cons

  4. Economics

    Evaluate Your Investment Portfolio For ...

  5. Investing Basics

    CDs or Bonds: Which Investment is Better ...

Trading Center