Philippe Jabre’s career in finance spans four decades, having established himself as a prominent figure in international asset management and investment. He is best known as the Founder, CEO and CIO of Jabre Capital Partners.
This article will look at convertible bonds, explaining how they work, and providing an overview of their key attractions from the investor’s perspective.
Convertible bonds are corporate bonds that convey to the holder the option of converting them into the common stock of the issuing company. They act just like regular corporate bonds when issued, albeit with a slightly lower interest rate.
Some companies issue convertible bonds known as “death spiral debts” that convert to a predetermined market value as opposed to a fixed number of shares. As these bonds are converted, they can effectively drive down the market share price.
Since they can be changed into stock, convertible bonds benefit from rises in underlying stock prices. Companies therefore offer lower yields on convertibles. Should the stock perform poorly, there is no conversion, and the investor is left with a bond’s subpar return, below that which a nonconvertible corporate bond would attract. As always, there is a trade-off between risk and reward.
Investors can purchase convertible bonds via an investment advisor, financial advisor or brokerage account, although the latter tend not to offer them since they are typically more complicated than other types of bonds. Investing in exchange-traded funds (ETFs), mutual funds, index funds, or closed-end funds holding convertible bonds can be a convenient workaround.
From a company’s perspective, there are two main reasons to issue convertible bonds. The first is that issuing convertible bonds lowers the coupon rate on debt, with investors typically accepting a lower coupon rate on a convertible bond compared with that on an otherwise identical regular bond due to its conversion feature. This enables companies to save on interest expenses, potentially achieving substantial savings in the case of a large bond issue.
The second reason is to delay dilution. Raising capital by issuing convertible bonds as opposed to equity allows the company to delay dilution to existing shareholders. An issuer may find itself in a situation where it is desirable to issue a debt security in the medium turn, particularly since interest expense is tax deductible. It may be comfortable with dilution over the longer term, anticipating that its net income and share price will increase substantially over this timeframe. In this case, the issuer can force conversion at the higher share price, provided the stock has indeed risen past this level.
A key attraction of convertible bonds for investors lies in their ability to provide a fixed interest payment, just like traditional bonds, but with an added potential upside via capital appreciation of shares. Investors purchase convertible bonds from issuers that pose significant potential for future growth, receiving fixed interest payments. If the stock price reaches the conversion level, investors can obtain equity shares in the company.
Combining fixed income and equity features, the hybrid features of convertible bonds make them an attractive option for many investors, particularly those seeking capital efficiency, improved risk-adjusted returns, and enhanced portfolio diversification. Participating meaningfully in equity market rallies, convertible bonds also provide downside protection thanks to their bond component. Historically, convertibles have delivered strong risk-adjusted performance, with a beta of 0.73 to the S&P 500.
Nevertheless, convertible bonds also have their downsides from the investor’s perspective, the chief being the issuer’s right to forcibly convert them. This usually occurs when the stock price is higher than the amount due if the bond were redeemed. Alternatively, the issuer may also force conversion at the bond’s call date.
