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What is a convertible bond?

What is a convertible bond

A convertible bond is a debt security with a fixed income that can be converted into shares of the issuing company. A conversion to stock may be performed several times during the bond’s lifespan at the bondholder’s discretion. Usually, convertible bonds offer higher yields than common stock, but lower yields than traditional corporate bonds.

Where have you heard about the convertible bond?

Convertible bonds originated in the middle of the 19th century and were applied by early speculators, such as Daniel Drew and Jacob Little. Convertible bonds are often issued by companies with a low credit rating and high potential for growth. Convertible bonds are often served for seed investing in start-ups.  

What you need to know about the convertible bond

How do convertible bonds work? They represent a flexible option for companies, willing to get financing. Convertible bonds work as hybrid securities, which embody the features of a bond – such as an interest payment – and also provide the opportunity to own the stock. 

The conversion ratio of the bond determines how many shares you can obtain, converting one bond. For example, a 5 to 1 ratio means that one bond can be converted into 5 common stock shares.

The same as plain-vanilla corporate bonds, convertible bonds are designed to pay income to investors. However, they can rise in price, when the issuing company’s stock performs well, unlike corporate bonds. Since the convertible bond provides the opportunity to be converted into stock, the rising stock price can increase the value of the convertible security. If the underlying stock shows poor performance, the investor will not convert the security to stock and will hold it until maturity.

Convertible bonds examples:

  • Vanilla convertible bonds have a simple convertible structure. They provide holders with the right to convert the bond into a particular number of shares, determined according to a pre-defined conversion price.  This is the most common convertible type, which presupposes coupon regular payments and have a fixed maturity date.

  • Mandatory convertibles work as a variation of the vanilla type, particularly on the US market. This example of convertible forces the bond holder to convert into shares at the maturity date, this is why it is called “Mandatory”. 

  • Reversed convertibles represent a less widespread example of convertible bonds. It provides the issuing company with a right to convert the bond to equity shares or keep it as a fixed income investment until maturity.

  • Packaged convertibles are also called a “bond + option” structure. It usually represents a straight bond and a call option wrapped together.

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