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. When should a company consider issuing a corporate bond vs. issuing stock?

    Understand when a company should consider issuing a corporate bond versus issuing stock, and learn about the underlying principle ...
  2. How is a corporate bond taxed?

    Understand the three components of a corporate bond that are subject to taxes. Learn about the ways the federal and state ...
  3. Why is Manchester United (MANU) carrying so much debt?

    Learn how the Glazer family incurred substantial debt for its takeover of Manchester United, and understand how that debt ...
  4. How do I use the principles of convexity to compare bonds?

    Read a brief overview of bond duration and bond convexity and why bondholders should take these into consideration when deciding ...
RELATED TERMS
  1. Accelerated Return Note (ARN)

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

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

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

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

  6. Promotional CD rate (Bonus CD rate)

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

You May Also Like

Related Articles
  1. Mutual Funds & ETFs

    How To Short The U.S. Bond Market

  2. Mutual Funds & ETFs

    The EMAG Emerging Mkts Bond ETF: Worth ...

  3. Mutual Funds & ETFs

    5 Dividend ETFs with Growth Potential

  4. Investing

    Feeling Risk-Averse? Consider These ...

  5. Mutual Funds & ETFs

    Top Mortgage-Backed Securities ETFs

Trading Center