Convertible bonds are considered 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. Issuing convertible bonds can be a flexible financing option for companies and tend to be more useful for companies with high risk/reward profiles.
How the Bonds Are Converted to Stock
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.
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.
For example, Carnival Corp. (CCL) issued some zero-coupon convertible bonds back in 2003 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, making for a highly dilutive conversion and impact to their existing positions.
(To learn more, see Convertible Bonds: An Introduction.)