What Is a Convertible Bond?
Convertible bond is a bond that can be exchanged for a fixed number of the issuer's shares at the holder's choice. You accept a lower coupon than a plain bond in return for that conversion right, so the instrument behaves like debt when the shares are weak and like equity when they are strong.
A convertible bond is two instruments in one wrapper: a corporate bond, and a call option on the issuer’s shares. Everything it does follows from which of the two is currently in charge.
How it works
It pays a coupon like any bond and matures like any bond. The difference is a right — you may exchange it for a set number of shares instead of taking the cash back.
The conversion right is not a gift. A convertible pays less than the same company’s plain debt, and that shortfall is the option premium, paid in instalments out of income you would otherwise have had.
When the shares run, the option dominates. The conversion right becomes the valuable part and the price starts tracking the equity.
When the shares fall, the bond dominates. The option becomes close to worthless and the price settles toward what the debt alone is worth — the bond floor.
The switch is the point
The appeal is asymmetry: equity upside with a floor underneath. That is a genuine property and it is paid for, twice over — in the reduced coupon, and in the conversion terms being set above today’s share price so the shares must rise materially before the option is worth anything.
Volatility helps you here, which is unusual for a bondholder. The option component is worth more when the shares move more, so a rise in expected movement lifts the convertible even if nothing else changes — which volatility covers as a measure in its own right.
The floor is not a floor
The floor is the value of the debt, and debt is only worth something if the company can pay.
The case that breaks it: a company in real trouble. The shares collapse, so the option is worthless. The company’s credit deteriorates, so the bond floor falls too. Both halves fail together, because both are claims on the same business.
Which is exactly when the protection was wanted. The asymmetry is real in ordinary conditions and weakest in the conditions people buy it for.
A worked example
A convertible paying 2% where the company’s plain debt pays 5%, convertible into shares currently 30% below the conversion price.
You gave up 3% a year. Over a five-year life that is roughly 15% of face value, handed over for an option that is out of the money.
The shares must rise more than 30% before the option pays anything at all, and more than that before the total beats simply having owned the plain bond. Neither of those thresholds appears on the front page of the offering.
The original data
Use this site’s thirty-year fee measurement for what annual percentages compound to: 5 basis points costs 1.5% of the final balance, 20 costs 5.8%, 75 costs 20.2%, 150 costs 36.5%.
Now price the foregone coupon. Giving up 3 percentage points a year is 300 basis points — twice the largest figure in that table, paid every year for the life of the bond, in exchange for an option that may expire worthless. That is the honest cost of the asymmetry, and it is not small.
And convertibles trade thinly. A round trip on this site’s shared series is 0.0098, about 2% of the median bar range of 0.493 — and a convertible’s dealer spread is wider still, because the instrument is specialised and the buyer pool is small.
Why companies issue them
A convertible lets a company borrow more cheaply than its credit alone would allow. The option sweetens the deal, so the coupon can be set below what plain debt would cost.
It is also equity issued at a delay and at a higher price. If the shares perform, the bonds convert and the debt disappears — replaced by shares sold above where they trade today. That is attractive to a company that thinks its shares are undervalued.
Which is the signal worth noticing. Convertibles cluster in companies that are growing, unprofitable, or both — issuers who want equity-like funding without selling shares at the current price. The structure is telling you something about who is on the other side of it.
And existing shareholders get diluted if it converts, which is the cost the company accepted in exchange for the cheaper coupon.
When it fails
The characteristic failure is buying it as a safer way to own the shares. The pitch is upside with downside protection, and it holds in ordinary conditions. In the conditions that actually threaten the company, both components deteriorate at once — the option goes worthless as the shares collapse, and the floor sinks as the credit does. The instrument was never two independent exposures; it was two claims on one business, and they fail together.
A second failure is ignoring how far out of the money the conversion is. The shares often have to rise substantially before the right is worth anything.
A third is forgetting it can be callable too. Many convertibles let the issuer force conversion once the shares clear a level, which caps the upside you paid for.
A fourth is treating the lower coupon as a bargain price. It is the premium, charged in instalments.
And a fifth is holding it in size in a single name, which concentrates credit risk and equity risk in the same position — the concentration leverage makes expensive elsewhere.
Related
Corporate bond covers the debt half and the credit risk underneath. Volatility covers the variable that prices the option half. And leverage covers what concentration in a single issuer does to an account.
A convertible is the mirror image of a callable bond. There you sold an option and were paid in extra coupon; here you bought one and paid in reduced coupon. Same mechanism, opposite direction — and knowing which side of that trade you are on tells you most of what you need about any bond with a feature bolted to it.
— Michael Whitman
This page is educational, not financial advice. Test every idea on your own charts before risking money.