Convertible Bonds are bonds issued by Corporations that can be converted into shares in the firm should the holder so prefer. In return for this opportunity, their yields tend to be below that of non-convertible bonds but above the yields available on the common stock. They can be seen as a bond with a stock call option attached.
Bond Plus Option
Typically, the convertible bond will enable the holder to buy shares in the company at a pre-determined price and point in time, whilst still paying interest as with a conventional bond.
As the share price rises the option to convert into the shares becomes more valuable, in the same fashion as with an equity Call option.
As a hybrid security, Convertibles are affected by interest rate changes and changing perceptions of the company’s credit rating (as with straight bonds) and moves in the price of the underlying shares.
It thus has the characteristics of both bonds AND shares- more price volatile than bonds, but less so than shares.
So, assuming no change in the credit rating of the firm, if the share price rises, the value of the CB will rise, whereas if the share falls (or interest rates rise), its value will normally fall.
This is not always the case, however, as if the bond is callable, (whereby the company can force the investor to sell the bonds back to the company), a rise in the share price may cap the bond’s price gain- conversely, if it is puttable, the downside risk is limited as this feature enables the holder to sell (or put) the bonds back to the issuer.
Benefits Of Convertible Bonds
For issuing firms, the benefit of Convertible bond issuance is a lower coupon, (which lowers funding costs), whilst the buyer of the bond sees price appreciation potential with the protection of a defined maturity date at which the bond is redeemed (usually at par).
In addition, as the bonds are above common equity holders in the credit structure in the event of bankruptcy, they are less risky than common shares.
On the other hand, should the bonds be converted, existing shareholders will suffer dilution, as new shares are created which will tend to dampen EPS and other per share valuation metrics.