Convertible Bonds

Convertible Bond Features: Hybrid Financing Instruments

Convertible bonds, or "convertibles," are hybrid financing instruments that blend the traditional features of debt and equity.

Convertible bonds provide the bondholder with the option to convert the bonds into equity if certain conditions are met.

The differentiating factor of convertible bonds is their “equity-kicker”, where the bonds can be exchanged for a pre-determined number of equity shares.

Until converted, the issuer is obligated to pay interest periodically to the bondholder, who can redeem the bonds for a set time frame to receive either:

• Equity – Shares in the underlying company issuing the bonds, i.e. partial equity ownership
• Cash – Cash proceeds of equivalent value to an agreed-upon number of shares

Convertible Bonds Investing: Debt and Equity Component

The appeal of convertible bonds for bondholders is the added optionality of equity participation for equity-like returns along with bond-like protection, creating a more balanced risk/reward profile.

• Upside Potential – If the share price of the underlying issuer rises, bondholders can earn equity-like returns post-conversion via price appreciation.
• Downside Risk Mitigation – If the share price of the underlying issuer declines, bondholders can still receive a consistent stream of income through interest payments and repayment of the original principal.

The decision to convert the bonds into equity is up to the bondholder, with the main consideration being the share price of the underlying company.

Like options, bondholders usually opt to convert the bonds into common shares only if doing so results in a higher return than the yield on the bonds.

• Debt Component – The market price varies based on the prevailing interest rate environment and the borrower's creditworthiness (i.e. perceived default risk).
• Equity Component – The share price of the underlying company is the prime consideration, which is priced based on recent operating performance, investor sentiment, and ongoing market trends, among numerous other factors.

Convertible Bonds: Lending Terms

Convertibles are issued with the key terms clearly stated within the loan agreement, as well as the details regarding the conversion option.

• Principal – The face value (FV) of the bond, i.e. the amount invested in the convertible bond offering
• Maturity Date – The maturity of the convertible bonds and range of dates on which conversion could be done, e.g. conversion only at predetermined times
• Interest Rate – The amount of interest paid on the outstanding bond, i.e. not yet converted
• Conversion Price – The share price at which conversion occurs
• Conversion Ratio – The number of shares received in exchange for each convertible bond
• Call Features – The right of the issuer to call a bond early for redemption
• Put Features – The right of the bondholder to force the issuer to repay the loan at a date earlier than originally scheduled

Convertible Bond Calculation Example

The issuer offering convertible bonds typically expects their share price to appreciate in value.

For example, if a company seeks to raise $10 million and the current share price is $25, then 400,000 new shares must be issued to reach its capital raising target.

• $10 million = $25 x [Shares Issued]
• Shares Issued = 400,000

With convertible debt, the conversion could be deferred until its share price has increased.

If we assume the company's shares have doubled and are currently trading at $50 per share, the number of shares issued is cut in half.

• $10 million = $50 x [Shares Issued]
• Shares Issued = 200,000

As a result of the higher share price, the number of shares issued to reach the target declines to 200,000, partially reducing the net dilutive impact.

Advantages of Convertible Debt

Convertible bonds are a form of "deferred" equity financing, reducing the net impact of dilution if the share price appreciates later.

Convertible bonds can be a preferable method of raising capital because the issuance is contingent on meeting two conditions:

1. The current share price must reach a certain minimum target threshold
2. The conversion can only occur within the stated time frame

In effect, the contractual provisions function as a hedge against dilution.

The bondholder receives downside protection – i.e. protection of the original principal and source of income via interest, barring default – as well as the potential for equity-like returns if converted.

However, most convertible bonds contain a call provision that allows the issuer to redeem the bonds earlier, which caps the capital gain potential.

Disadvantages of Convertible Debt

The exchange feature attached to convertibles could enable a bondholder to earn outsized returns, yet the returns stem from share price appreciation post-conversion rather than interest.

Why? The option to convert comes at the expense of a lower coupon, i.e. interest rate.

Relative to other fixed-income securities, convertibles are often more volatile, as the equity option component is a derivative of the underlying company's share price.

Conversion can still cause a company’s earnings per share (EPS) and share price to decline, despite the reduced dilution compared to traditional equity issuances.

The treasury stock method (TSM) is the recommended approach to calculating diluted EPS and the total number of diluted shares outstanding, in order to take into account the potential dilutive effects of convertible bonds and other dilutive securities.

The final downside to convertible bonds is that these securities, particularly those designated as subordinated convertible bonds, are lower in the capital structure than the other debt tranches.