What Are Convertibles?

Convertibles are securities, usually bonds or preferred shares, that can be converted into common stock. Convertibles are most often associated with convertible bonds, which allow bondholders to convert their creditor position to that of an equity holder at an agreed-upon price. Other convertible securities can include notes and preferred shares, which can possess many different traits.

Key Takeaways

  • A convertible is a bond, preferred share, or another financial instrument that can be converted by the shareholder into common stock.
  • Convertible securities are not classified as debt or equity; instead, they are considered to be a hybrid of the two categories, possessing cash flow features of both bonds and stocks.
  • Convertibles appeal to investors because they provide protection against big losses, and pay higher income than common stock.
  • However, on the downside, it is not always profitable to convert bonds into equities, and most convertible bonds have a feature that allows the company to force investors to convert at a certain time.

Understanding Convertibles

Convertibles are ideal for investors demanding greater potential for appreciation than bonds provide, and higher income than common stocks offer. Convertible bonds, for instance, typically offer a lower coupon than a standard bond. However, the optionality of the bond to convert to common stock adds value for the bondholder.

There are three main types of investments: debt, equity, and some hybrid form of the two. Convertible securities fall into the hybrid category because they have cash flow features of both a bond and a stock.

Like other bonds, convertible bonds are considered debt. In exchange for the use of investor funds, the company agrees to pay the investor a set rate of interest referred to as the coupon rate. Unlike other bonds, convertibles also give the holder the right to convert the bond into shares of stock.

Investors like convertibles because they offer protection against heavy losses, but they also give up some value in appreciation. Most convertible bonds are callable, which means the company can force investors to convert. In this case, the upside potential of convertibles is not unlimited.

While convertible bonds can be very valuable if the company's share price sees a large increase, the fact that convertibles are callable not only limits that upside, it can sometimes force investors to take a loss if the issuer forces investors to convert at an inopportune time.

Types of Convertible Bonds

A vanilla convertible bond, perhaps the least complicated convertible, provides the investor with the choice to hold the bond until maturity or convert it to stock. If the stock price has decreased since the bond's issue date, the investor can hold the bond until maturity and get paid the face value. If the stock price increases significantly, the investor can convert the bond to stock and either hold or sell the stock at their discretion. 

On the other hand, mandatory convertible bonds are required to be converted by the investor at a particular conversion ratio and price level. Furthermore, a reversible convertible bond gives the company the right to convert the bond to equity shares or keep the bond as a fixed income investment until maturity. If the bond is converted, it is done so at a preset price and conversion ratio.

Conversion Rate

The rate at which investors can convert bonds into stocks—that is, the number of shares an investor gets for each bond—is determined by a metric called the conversion rate. The conversion rate may be fixed or change over time depending on the terms of the offering. A conversion rate of 30 means that for every $1,000 of par value the convertible bondholder converts, she receives 30 shares of stock. It is not always profitable to convert bonds into equity. Investors can determine the breakeven price by dividing the selling price of the bond by the conversation rate.

Example Convertible Calculation

In this example, a convertible bond has a par value of $1,000 and a selling price of $800. The shares of this company are selling for $40. The share price at which the convertibility feature becomes profitable is calculated by dividing $800 by 30, the conversion rate. The answer is $26.67, which is much less than $40. An investor can decide to convert and take profit at this point. If the bond never becomes profitable, the holder receives the bond’s stated interest rate.