A convertible bond is a type of corporate bond that can be exchanged for a set number of the company’s shares. It combines features of a bond, which pays interest and returns your money at maturity, with some of the upside of owning shares. This guide explains how convertibles work and the risks to consider.
Risk warning: The value of investments can go down as well as up, and you may get back less than you invest. Bonds carry credit, interest rate and liquidity risk. This article is for education only and is not investment advice.
How a convertible bond works
- Interest: like a normal bond, it pays a regular coupon, usually lower than a similar non-convertible bond.
- Maturity: if it is not converted, the issuer is meant to repay the face value at the end of the term.
- Conversion ratio: the number of shares you receive for each bond if you convert.
- Conversion price: the effective share price at which conversion happens. If the share price rises well above it, converting becomes attractive.
- Conversion premium: how much more the bond costs compared with the current value of the shares it converts into.
A simple example
Imagine a bond with a face value of $1,000 that converts into 20 shares, giving a conversion price of $50 per share. If the share price is $40, converting would give you shares worth $800, so you would usually keep the bond and its interest. If the share price rises to $70, the shares would be worth $1,400, so the bond’s value tends to rise with the shares.
Why companies issue convertibles
Companies, often fast-growing ones, issue convertibles because they can usually pay a lower interest rate than on regular bonds. In return, investors get the chance to share in future share price gains.
Potential benefits for investors
- Regular interest payments.
- Potential to benefit if the share price rises.
- Usually less sensitive to share price falls than owning the shares directly, as long as the issuer stays financially healthy.
Risks to understand
- Credit risk: if the company gets into financial trouble, it may not pay interest or repay the bond, and convertibles are often issued by riskier companies.
- Lower income: coupons are usually lower than on comparable regular bonds.
- Dilution: conversion creates new shares, which can weigh on the share price.
- Call features: some issuers can redeem the bonds early, forcing investors to convert or sell at an unfavourable time.
- Complexity and liquidity: convertibles can be harder to value and to sell quickly than shares or government bonds.
- Interest rate risk: like other bonds, prices can fall when interest rates rise.
How individuals can invest
Individual convertible bonds are often traded in large sizes, so many private investors gain exposure through funds that hold a range of convertibles. As with any fund, check the fees, the strategy and the risks in the fund documents.
Summary
Convertible bonds sit between bonds and shares: they pay interest, but can be converted into equity if the share price rises. They can offer a balance of income and growth potential, but they carry credit, complexity and dilution risks. Read more about bonds in our Bonds section.