A:

First, let's define convertible bonds. A unique combination of debt and equity, they provide investors with the chance to convert a debt instrument into shares of the issuer's common stock, at a set price and usually by a set date. This is usually done at the discretion of the bondholder, but in some cases, the trigger on convertible bonds is share price performance - as soon as the issuer's share price reaches a given threshold, the bonds convert automatically.

Convertible bonds are a bone of contention among some investors and shareholder advocates. Why? Because the stocks that convertible bondholders get when they convert their bonds come in the form of newly issued securities. Therefore, in the absence of anti-dilution provisions, convertible bonds almost always dilute the ownership percentage of current shareholders. Here's an example from October 2003 found in Carnival Cruiselines' (NYSE:CCL) quarterly report:

Carnival issued some zero-coupon convertible bonds that automatically converted to stock if Carnival's share price hit $33.77. According to the terms of the indenture, convertible bondholders would be allowed to buy the company's stock at $30.70 per share. Since the bonds didn't pay much interest, the $3.07 difference between the market price and the conversion price of the bonds provided bond investors a bit of a sweetener for buying the bonds. Unfortunately for stockholders who didn't own the bonds, the bonds converted to over 17 million shares of stock - a highly dilutive conversion.

The result is that stockholders own a smaller piece of the pie after bondholders convert their holdings. One of the main reasons that convertible bonds are so frustrating for shareholders is that most small time investors don't ever get the chance to buy them. Convertible bonds with the juiciest conversion features - low conversion prices, preferential conversion ratios and above-market interest rates - are issued in private placements to investors who already have financing relationships with the company. Unfortunately for the common investor, this practice is unlikely to change in the near future.

To learn more, see Convertible Bonds: An Introduction.

RELATED FAQS
  1. What is a convertible bond?

    A convertible bond is a bond issued by a corporation that, unlike a regular bond, gives the bondholder the option to trade ... Read Answer >>
  2. What are 'death spiral' convertible bonds?

    Conventional convertible bonds give the bondholder the right to exchange the bond for a certain amount of the issuer's common ... Read Answer >>
  3. 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 >>
  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 is dilutive stock?

    Dilutive stock is any security that dilutes the ownership percentage of current shareholders - that is, any security that ... Read Answer >>
Related Articles
  1. 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.
  2. Bonds & Fixed Income

    The Top 6 Convertible Bond Funds for 2016

    Take a look at convertible bond mutual funds that are well-positioned heading into 2016, and why investors might consider a convertible fund portfolio.
  3. Bonds & Fixed Income

    The Wonders Of Convertible Bonds

    Ever wondered what exactly a convertible bond does? Read the features of a convertible bond and learn how important the conversion factor is to you as an investor.
  4. Mutual Funds & ETFs

    3 Best High-Yielding Convertible Bond Mutual Funds (LACFX, FACVX)

    Discover an often overlooked asset class and how your portfolio can benefit from it, and learn about three of the highest-yielding options available.
  5. Mutual Funds & ETFs

    The Top 3 Convertible Bond ETFs for 2016 (CWB, ICVT)

    Obtain detailed information on the exchange-traded funds (ETFs) available for traders seeking ETF exposure to convertible bond investments.
  6. Stock Analysis

    Convertible Securities In Today's Market

    John Calamos, the father of convertible investing, moderated a panel on convertible bonds at the Milken Global Conference April 27.
  7. Bonds & Fixed Income

    Introduction To Convertible Preferred Shares

    These securities offer an answer for investors who want the profit potential of stocks but not the risk.
  8. 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.
  9. Stock Analysis

    Playing Convertibles With Calamos

    Boutique firm Calamos is a specialist in convertible bonds; find out where you can get involved.
  10. 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.
RELATED TERMS
  1. Convertible Bond

    A bond that can be converted into a predetermined amount of the ...
  2. Premium Put Convertible

    A convertible bond with an additional put feature that allows ...
  3. Convertible Bond Arbitrage

    An arbitrage strategy that aims to capitalize on mispricing between ...
  4. Convertible Hedge

    A trading strategy that consists of a long position in a company's ...
  5. Bond Floor

    1. The lowest value that convertible bonds can fall to, given ...
  6. Asset Swapped Convertible Option Transaction - ASCOT

    An option on a convertible bond that is used to separate a convertible ...
Hot Definitions
  1. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  2. 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, ...
  3. 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.
  4. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  5. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  6. Sharing Economy

    An economic model in which individuals are able to borrow or rent assets owned by someone else.
Trading Center