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. Contingent Convertibles - CoCos

    A security similar to a traditional convertible bond in that ...
  4. Convertible Bond Arbitrage

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

    An investment that can be changed into another form. The most ...
  6. Convertible Arbitrage

    A trading strategy that typically involves taking a long strategy ...
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

    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.
  3. Investing

    Leverage Your Returns With A Convertible Hedge

    Find out how you can maintain your income stream by using this type of bond strategy.
  4. 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.
  5. Investing

    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.
  6. Investing

    CWB: SPDR Barclays Convertible Secs ETF

    Read an in-depth analysis of the SPDR Barclays Capital Convertible Bond ETF, which tracks an index of high-growth potential convertible bonds.
  7. Managing Wealth

    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.
  8. Investing

    Corporate Bond Basics: Learn to Invest

    Understand the basics of corporate bonds to increase your chances of positive returns.
  9. Investing

    Introduction to Convertible Preferred Shares

    These securities offer an answer for investors who want the profit potential of stocks but not the risk.
RELATED FAQS
  1. What is the difference between convertible and reverse convertible bonds?

    The difference between a regular convertible bond and a reverse convertible bond is the options attached to the bond. While ... 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. 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 >>
  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. What forms of debt security are available for the average investor?

    Discover the various different types of debt securities, issued by government entities or corporations, that are available ... Read Answer >>
Hot Definitions
  1. Interest Expense

    The cost incurred by an entity for borrowed funds. Interest expense is a non-operating expense shown on the income statement. ...
  2. Call Option

    An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument ...
  3. Pro-Rata

    Used to describe a proportionate allocation. A method of assigning an amount to a fraction, according to its share of the ...
  4. Private Placement

    The sale of securities to a relatively small number of select investors as a way of raising capital.
  5. AAA

    The highest possible rating assigned to the bonds of an issuer by credit rating agencies. An issuer that is rated AAA has ...
  6. Backward Integration

    A form of vertical integration that involves the purchase of suppliers. Companies will pursue backward integration when it ...
Trading Center