Loading the player...

What is a 'Convertible Bond'

A convertible bond is a type of debt security that can be converted into a predetermined amount of the underlying company's equity at certain times during the bond's life, usually at the discretion of the bondholder. Convertible bonds are a flexible financing option for companies and are particularly useful for companies with high risk/reward profiles. Convertible bonds are sometimes referred to as "CVs."!--break--Convertibles bonds are issued by companies for a number of reasons. Issuing convertible bonds is one way for a company to minimize negative investor interpretation of its corporate actions. For example, if an already public company chooses to issue stock, the market usually interprets this as a sign that the company's share price is somewhat overvalued. To avoid this negative impression, the company may choose to issue convertible bonds, which bondholders are likely to convert to equity anyway should the company continue to do well.

Another reason for issuing convertible bonds is that investors demand a security that optimally protests their principal on the downside but allows them to participate in the upside should the underlying company succeed. A startup or relatively new company, for example, may have a risky project that loses a great deal of money on one end but may lead the company into profitability and outsize growth. A convertible bond investor can get back some principal upon failure of the company but can benefit from capital appreciation by converting the bonds into equity if the company is successful. Convertible bonds are a useful financing option for both investors and companies when the company's success resembles a binary outcome.

Convertible bonds also allow the companies issuing them to lower their borrowing costs. From the investor's perspective, a convertible bond has a value-added component built into it; it is essentially a bond with a stock option, particularly a call option, attached to it. Thus, it tends to offer a lower rate of return in exchange for the value of the option to trade the bond into stock. Otherwise, the bond just pays interest to the investor for his capital investment.

Example of Convertible Bond

A company issues a $1,000 face value convertible bond paying 4% interest with a convertible ratio of 100 shares of the company for every convertible bond and a maturity of 10 years for $1,000. At the end of year nine, a year before maturity, the investor is entitled to $1,000 in principal plus $40 in interest payments, a total of $1,040 if the investor does not convert the bond into equity. However, the company's shares are now trading at $11 after a successful quarter; thus, 100 shares of the company are now worth $1,100 (100 share x $11 share price), surpassing the value of the bond. The investor is likely to convert the bond into equity, receiving 100 shares in the process, and he could sell them in the market for $1,100 in total.

BREAKING DOWN 'Convertible Bond'

RELATED TERMS
  1. Convertibles

    Securities, usually bonds or preferred shares, that can be converted ...
  2. Premium Put Convertible

    A convertible bond with an additional put feature that allows ...
  3. Revertible

    Refers to a special kind of convertible corporate bond that automatically ...
  4. Deferred Equity

    A type of security, such as preferred shares or convertible bonds, ...
  5. Foreign Currency Convertible Bond ...

    A type of convertible bond issued in a currency different than ...
  6. Contingent Convertibles - CoCos

    A security similar to a traditional convertible bond in that ...
Related Articles
  1. Financial Advisor

    Is Now the Time for Convertible Bonds?

    Convertible bonds offer a competitive rate of return in what is a very tough market right now. Here's how they work.
  2. Investing

    An Introduction to Convertible Bonds

    Getting caught up in all the details and intricacies of convertible bonds can make them appear more complex then they really are.
  3. Financial Advisor

    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).
  4. Investing

    Why Include Convertible Securities in Your Portfolio

    What are convertible securities and why you should include them in your portfolio.
  5. Investing

    3 Best High-Yielding Convertible Bond ETFs (CWB, ICVT)

    Discover how convertible bond ETFs can offer investors growth and income while hedging fixed income portfolios in a rising rate environment.
  6. Investing

    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.
  7. Investing

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

    LACFX,FACVX,VCVSX: Learn about three of the highest-yielding options available.
  8. Investing

    Leverage Your Returns With A Convertible Hedge

    Find out how you can maintain your income stream by using this type of bond strategy.
  9. Investing

    Can a Bond ETF Work in a Rising Rate Environment?

    The CWB Convertible Securities ETF could be the perfect solution for a rising rate environment.
  10. Investing

    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.
RELATED FAQS
  1. Why would a corporation issue convertible bonds?

    Discover how corporations issue convertible bonds to take advantage of much lower interest rates as a result of a conversion ... Read Answer >>
  2. Where does the stock come from when convertible bonds are converted to stock?

    First, let's define convertible bonds. A unique combination of debt and equity, they provide investors with the chance to ... Read Answer >>
  3. How do I use a premium put convertible?

    Holders of convertible bonds face all the pitfalls that traditional bondholders face - liquidity risk, interest rate risk ... Read Answer >>
  4. 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 >>
  5. 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 >>
Hot Definitions
  1. Fixed Cost

    A cost that does not change with an increase or decrease in the amount of goods or services produced. Fixed costs are expenses ...
  2. Blue Chip

    A blue chip is a nationally recognized, well-established, and financially sound company.
  3. Payback Period

    The length of time required to recover the cost of an investment. The payback period of a given investment or project is ...
  4. Collateral Value

    The estimated fair market value of an asset that is being used as loan collateral. Collateral value is determined by appraisal ...
  5. Fiduciary

    A fiduciary is a person who acts on behalf of another person, or persons to manage assets.
  6. Current Account

    The difference between a nation’s savings and its investment. The current account is defined as the sum of goods and services ...
Trading Center