Wondering what convertible bonds are and how they work? In a nutshell, convertible bonds allow you to earn fixed-rate interest payments until the bond matures. They are issued by large companies that wish to raise capital from outside investors. In this sense, they operate much like a traditional bond.
However, what sets convertible bonds apart is that the bondholder has the option to exchange the bonds for equity in the company. The amount is pre-determined before the issue, and depending on the type of convertible bond, the investor may opt to hold on to the bonds until maturity.
There’s much to learn about convertible bonds, so we would suggest reading this guide before making an investment. We explain the ins and outs of how convertible bonds work, how much you can make, and how you can make an investment today.
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What are Convertible Bonds?
Convertible bonds form part of the multi-trillion dollar corporate bonds space. In its most basic form, they operate in a similar nature to traditional bonds. For example, the bondholder will be entitled to bi-annual or annual interest payments, which are usually fixed.
This allows investors to earn passive income and know exactly how much yield they are going to make. In terms of maturity, convertible bonds also have an expiry date. This is determined by the company that issues them at the time of the capital raise.
With that said, let’s look at a quick example of how a convertible bond investment might work in practice.
- You purchase $20,000 worth of convertible bonds from James Company
- The bonds have a maturity date of 9 years and pay a yield of 4%
- This means that you will receive $800 in interest per year ($20,000 x 4%)
- At the end of the 9-year term, you would have received $7,200 in interest
- You will also receive your original $20,000 back at the end of the 9-year term
However, there are some key differences between convertible bonds and traditional bonds. At the forefront of this is the ability of the bondholder to ‘convert’ the bonds into common equity. For those unaware, common equity means that you own part of the company in question which is proportionate to the amount you invest. This is represented by stocks, so your investment will go up and down depending on how the shares perform in the open marketplace.
Pros and Cons of Investing in Convertible Bonds
- Convertible bonds allow you to earn a fixed rate of interest until they mature
- You are given the option of converting the bonds into equity
- Some convertible bonds give you the luxury of waiting for the stock price to increase before a conversion is made
- You can hold on to your convertible bonds if the company’s share price goes down
- You will have priority over shareholders in the event that the company ran into financial difficulties
- Some convertible bonds require you make the conversion on or before a pre-defined date
- They can be difficult to purchase if you’re a retail investor
- Minimum investments are typically quite high
- They offer a lower coupon rate than traditional bonds
How do Convertible Bonds Work?
If a company wishes to raise capital, it might decide to issue convertible bonds. As noted above, this gives investors the benefit of both worlds as you can earn fixed income while having the option of converting the bonds into equity. The company that sells the convertible bonds will typically be listed on a public stock exchange at the time of the issue, such as the New York Stock Exchange or NASDAQ.
Before the convertible bonds are issued, the company will need to determine the ‘conversion ratio’. This is the ratio at which the bonds can be converted into common equity. For example, let’s say that the conversion ratio stands at 4:1. This means that each bond you hold, you can then exchange it for 4 shares in the company. The conversion rate will not, and cannot, be changed once the bonds have been issued. This offers investors an element of security.
Let’s look at a quick example of how the convertible bond issuance process might work.
- Billy PLC wants to raise $10 million in the form of convertible bonds
- The bonds are issued in denominations of $10,000, meaning that there are 1,000 convertible bonds issued in total
- The bonds come with a conversion ratio of 3:1
- You invest a total of $30,000, meaning that you own 3 convertible bonds in Billy PLC
- If and when you decide to convert the bonds into common stock, you would own 9 shares in Billy PLC (3 bonds at a ratio of 3:1)
Convertible Bonds: When Should I Convert Them for Equity?
Although some convertible bonds do not give you the option of choosing when you can convert the bonds into equity, some do. As we cover in more detail later, ‘vanilla’ convertible bonds give you the freedom of exchanging them for equity as and when you see fit. This is highly beneficial because you can convert the bonds when market conditions go in your favor.
For example, let’s say that the company you hold the convertible bonds with experiences a surge in the stock market. As the value of the company increases, you would then be able to convert your bonds for shares. Similarly, if the value of the company went down, you could simply hold on to the bonds and enjoy the fixed-rate interest that they pay.
Confused? Let’s take a look at a couple of examples to explore when you might consider exchanging your convertible bonds for equity.
When to Exchange Your Convertible Bonds
To keeps things simple, we are going to use basic figures in this example so that you have a firm grasp of when you should and shouldn’t exchange your convertible bonds into common equity.
- Let’s say that Company X decides to issue a convertible bond with a face value of $500. The bonds pay an annual yield of 6% and have a maturity of 5 years. This means that you would earn $30 in interest each year for every $500 bond that you hold.
- The convertible bonds have a conversion ratio of 50:1, meaning that you would get 50 shares in Company X for every bond that you convert. For example, if you converted 2 bonds, you would receive 100 shares.
- At the time of the issue, Company X had a share price of $10 per share. This means that were you to convert your 1 bond straight away, they would be worth $500. This is because 1 convertible bond gets you 50 shares, so 50 shares at $10 per share amount to $500.
- 12 months later, Company X increases its stock price to $13 per share. You hold 1 convertible bond, which will get you 50 shares if you make the conversion. At $13 per share, this would amount to $650 worth of shares.
As you can see from the above example, convertible bonds allow you to ‘sit tight’ and assess how the share price moves in the market before a conversion is made. In this example, the stocks were worth $10 when you bought the convertible bonds. But, when the shares increased to $13, this allowed you to amplify the value of your investment by converting the bonds to shares. You could then sell the shares in the open market to lock-in your profits.
When NOT to Exchange Your Convertible Bonds
The company that you hold convertible bonds with won’t always experience an upsurge in the stock market. On the contrary, the value of shares could just as easily go down. This means that were you to exchange your convertible bonds at a lower share value than when you made an investment, you would lose money. In this instance, you would be best off holding on to your convertible bonds and collecting your annual interest payments.
Let’s stick with the same example as above, but in reverse.
- You are holding one convertible bond in Company X at $500. The conversion ratio is 50 shares per bond, and the current share price of Company X is $10.
- 12 months later, the share price of Company X goes down to $6.
- If you then converted your bond, you would receive 50 shares at $6 per share, which amounts to $300.
- As such, your investment would be worth $200 less than what you originally paid, should you make the conversion.
As you can see from the above example, it would not be worth converting your bonds when the share price goes down. Instead, it would be financially beneficial for you to keep the bonds are enjoy your fixed-interest payment of 6% per year. If the shares never recover, you would then get your original $500 investment back in full once the convertible bonds mature.
Types of Convertible Bonds
There are three types of convertible bonds that companies issue:
- Vanilla Convertible Bonds
- Mandatory Convertible Bonds
- Reverse Convertible Bonds
Here’s how each bond-type works.
Vanilla Convertible Bonds
The most sought-after convertible bond-type is that of vanilla bonds. In a nutshell, vanilla bonds give you the greatest freedoms. You will have the option, but not obligation, to convert the bonds to equity whenever you see fit. This means that you will benefit regardless of which way the markets go.
For example, if the price of the company’s shares goes up, you might decide to convert your bonds to benefit from the upsurge. Alternatively, if the share price goes down, you can keep hold of your convertible bonds to earn annual interest. If the shares fail to increase before the bonds mature, you will simply get your principal investment back in full, plus the interest you have already collected.
Mandatory Convertible Bonds
Mandatory convertible bonds are slightly less favorable for the investor, not least because they come with a pre-defined redemption date. You will be forced to convert your bonds on or before the redemption date. For example, let’s say that you buy mandatory convertible bonds on January 10th 2020 at a yield of 4%. The issuer stipulates that the bonds must be converted by no later than January 10th 2022 – subsequently giving you a grace period of 2 years.
In this example, only one of two things can happen.
- You decide to convert your bonds for shares before January 10th 2022
- You don’t convert your bonds before the redemption date, so they are automatically converted into share by the issuer on January 10th 2022.
On the one hand, you are still afforded an element of security on your mandatory convertible bonds, as you can exchange them before the redemption date if the value of the company’s shares increases. However, if this doesn’t happen and the shares go down, then you will be forced to convert them on the redemption date at a nominal loss.
Reverse Convertible Bonds
Reverse convertible bonds come with even less flexibility than mandatory bonds. This is because the issuer has the remit to convert them at any given time. There is no redemption period like you get with mandatory convertible bonds, so you don’t have the ability to base your decision on the company’s shares performance in the stock markets.
It is also important to note that you are not guaranteed to have the reverse convertible bonds exchanged into equity. The issuer also has the right to convert them to cash or debt instruments. On the flip side, this lack of flexibility typically results in much higher coupon payments. This allows you to earn an attractive amount of interest until the bonds are eventually converted by the issuer.
How do I Buy Convertible Bonds?
Whether it’s vanilla, mandatory, or reverse convertible bonds – accessing this particular segment of the bond arena is no easy feat for the average investor. This is because companies will usually issue convertible bonds directly to the institutional space. This includes the likes of banks, hedge funds, mutual funds, and even private investors.
With that being said, there is a slight workaround if you really want to invest in convertible bonds. You can do this through a mutual fund that has some, or all, of its asset basket made up of convertible bonds. The only drawback to this is that you won’t personally have the ability to dictate when the bonds are converted. Instead, this will be determined by the provider you invest with.
Nevertheless, below we’ve outlined a step-by-step guide on how you can invest in convertible bonds today!
Step 1: Choose a Mutual Fund That Specializes in Convertible Bonds
First and foremost, you will need to perform some online research to find a mutual fund that specializes in convertible bonds. In most cases, the mutual fund will invest in broader convertible securities. This means that its portfolio might contain both bonds and debt instruments where all assets will be convertible.
For example, the Fidelity Convertible Securities Fund has been buying and selling convertible securities on behalf of investors since 1987. The fund seeks both fixed-income and capital gains, and it returned a rather juicy yield of 20.35% for investors last year. This is just one example of many convertible bond funds available in the marketplace, so be sure to do your own research prior to making an investment.
Step 2: Open an Account and Verify Your Identity
Once you’ve found a convertible bond mutual fund that you like the look of, you will then need to open an account. Regardless of which trading platform you sign up with, you will need to provide some personal information. This will include your:
- First and Last Name
- Home Address
- Date of Birth
- Social Security Number (if US-based)
- Tax Status
- Contact Details
You will also need to provide some information on your current financial standing. For example, you’ll be asked how much you earn each year and the amount that you are planning to invest in the platform. You will also need to verify your identity before you can proceed to the next stage. You will likely be asked to upload a copy of your government-issued ID; such as your passport or driver’s license. You might also need to provide a proof of address.
Step 3: Deposit Funds
Once your account is verified with the mutual fund provider, you will then need to deposit some funds. You can normally do this with a bank transfer, although some mutual funds also support debit/credit cards. Either way, make sure you check what the minimum deposit amount is.
Step 4: Invest in Your Chosen Convertible Bond Fund
Once your account is funded, you can then invest in your chosen convertible bond fund. Simply choose how much you want to invest to complete the process. One of the best advantages of using a mutual fund to access to the convertible bond space is that you can exit your investment at any time. This means that you are not locked into an investment that you no longer want to hold.
By reading our guide on convertible bonds from start to finish, we hope that you now have a firm understanding of how the investment space works. It’s a complex battleground to get your head around at first, especially when you consider that there are three types of convertible bonds. The most favorable option is that of vanilla bonds, not least because you have 100% control of when/if you exchange them. With that said, although the likes of mandatory and reverse convertible bonds come with less flexibility, they usually offer a higher yield than vanilla bonds.
Ultimately, if you’re an everyday retail investor, accessing the convertible bond industry is not easy. This is because companies usually sell convertible bonds directly to institutional investors. We’ve outlined a workaround on this by investing in a mutual fund that specializes in convertible securities, you can access the marketplace at the click of a button.
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How do I make money with convertible bonds?
Much like a traditional bond, convertible bonds pay a fixed rate of interest. You'll receive this until the bonds are converted into equity. When they are, you will then hope to make money when the value of the shares increases in the open marketplace.
Are convertible bonds risky?
Like any investment product, convertible bonds do come with their risks. For example, if the issuer runs into financial difficulties, you might not receive your coupon payments or worse, your principal. Similarly, if and when the bonds are converted, you will lose money if the value of the shares goes down.
What is the minimum amount I can invest in convertible bonds?
If you're an everyday retail investor, you might find it difficult to access the convertible bonds space. This is because issuers will usually sell them directly to institutional investors at a 6 or 7-figure minimum. The only way around this is to use a mutual fund that specializes in convertible securities.
When do I need to convert my bonds?
This depends on the type of convertible bond that you have invested in. If you're holding vanilla bonds, you can convert them whenever you like, or choose not to convert them at all.
Do convertible bonds have a maturity date?
Yes, convertible bonds will always have a maturity date. If the bonds are not converted before this date, you will simply receive your original principal back.
When should I convert my convertible bonds?
If you have the option of converting your bonds, you should do so when the value of the company's shares surges. Make sure that the gains exceed that of the coupon yield offered by the bonds.
How do reverse convertible bonds?
Reverse convertible bonds allow the issuer to determine when the bonds are converted. The issuer can also decide whether the bonds should be converted in to equity, debt, or cash.