Convertible bonds give bondholders the right to convert their bonds into another form of debt or equity at a later date, at a predetermined price and for a set number of shares. Reverse convertible bonds give the issuer the right, but not the obligation, to convert the bond's principal into shares of equity, cash or another form of debt at a set date.

In other words, convertible bonds and reverse convertible bonds both offer the same sort of conversion rights—but those rights belong to different parties. With both instruments, the conversion feature is essentially a sort of embedded derivative, known as an option. The difference between the two relates to the structure of the options attached to the bond.

How Convertible Bonds Work

Convertible bondholders are not obligated to convert their bonds to common stock, but they may do so if they choose. The conversion feature is analogous to a call option that has been attached to the bond.

If the equity or debt underlying the conversion feature increases in market price, convertible bonds tend to trade at a premium. If the underlying debt or equity decreases in price, the conversion feature will lose value. But even if the convertible option comes to be of little value, the convertible holder still holds a bond that will typically pay coupons and the face value at maturity.

Convertible bonds are a flexible financing option for companies and tend to be quite useful for companies with high risk/reward profiles. The yield on this type of bond is lower than a similar bond without the convertible option because this option gives the bondholder additional upside.

How Reverse Convertible Bonds Work

Like their convertible bond cousins, reverse convertible bonds come with an embedded options feature. But in this case, the embedded option is a put option that is held by the bond's issuer on a company's shares. The option allows the issuer to “put” the bond's principal to bondholders at a set date for existing debt, cash or shares of an underlying company. The underlying company may be the issuer's own, or it may be a completely different company, unrelated in any way to the issuer's business.

Issuers generally exercise the reverse convertible bond's option if the underlying shares have fallen below a set price, often referred to as the knock-in level, in which case the bondholders will receive the stock rather than the principal and any additional coupons. Obviously, doing so can save the issuer a lot of money.

As an example, say XYZ bank issues a reverse convertible bond on the bank's own debt with a built-in put option on the shares of ABC Corp., a blue chip company. The bond may have a stated yield of 10% to 20%, but if the shares in ABC decrease substantially in value, the bank holds the right to issue the blue-chip shares to the bondholder, instead of paying cash at the bond's maturity.

Reverse convertible bonds tend to have short terms to maturity. Unsurprisingly, their yields tend to be higher than a similar bond without the reverse option—because of the risk involved for investors, who may be forced to accept shares in a company in lieu of their interest income and repayment of principal.