How do convertible bonds work

The answer is that they can be both, but not at the same time. Essentially, convertible bonds are corporate bonds that can be converted by the holder into the common stock of the issuing company. As the name implies, a convertible bond gives the holder the option to convert or exchange it for a predetermined number of shares in the issuing company.

When issued, they act just like regular corporate bonds, albeit with a slightly lower interest rate. Because convertibles can be changed into stock and, thus, benefit from a rise in the price of the underlying stock, companies offer lower yields on convertibles.

If the stock performs poorly, there is no conversion and an investor is stuck with the bond's sub-par return—below what a non-convertible corporate bond would get. As always, there is a tradeoff between risk and return. Companies issue convertible bonds or debentures for two main reasons. The first is to lower the coupon rate on debt. Investors will generally accept a lower coupon rate on a convertible bond, compared with the coupon rate on an otherwise identical regular bond, because of its conversion feature.

This enables the issuer to save on interest expenses, which can be substantial in the case of a large bond issue. The second reason is to delay dilution. Raising capital through issuing convertible bonds rather than equity allows the issuer to delay dilution to its equity holders. A company may be in a situation wherein it prefers to issue a debt security in the medium-term—partly since interest expense is tax-deductible—but is comfortable with dilution over the longer term because it expects its net income and share price to grow substantially over this time frame.

In this case, it can force conversion at the higher share price, assuming the stock has indeed risen past that level. The conversion ratio—also called the conversion premium—determines how many shares can be converted from each bond.

This can be expressed as a ratio or as the conversion price and is specified in the indenture along with other provisions. The chart below shows the performance of a convertible bond as the stock price rises. Notice the price of the bond begins to rise as the stock price approaches the conversion price. At this point, your convertible performs similarly to a stock option. As the stock price moves up or becomes extremely volatile, so does your bond. It is important to remember that convertible bonds closely follow the underlying share price.

The exception occurs when the share price goes down substantially. In this case, at the time of the bond's maturity, bondholders would receive no less than the par value. One downside of convertible bonds is that the issuing company has the right to call the bonds. Investment works in cycles of loaning money and cashing out. Each cycle is considered a round. Companies often enter into another round with the same or another investor after debt converts. Companies can go through many rounds of investing and converting over the life of the business.

Sometimes a warrant or discount are terms of a convertible loan. Sometimes there's a limit on the value of the debt when it's converted. These terms apply to a single round of investments. Another convertible loan option is a discount; these are usually 20 or 25 percent. When the loan converts at the end of the round, the investor can buy stock at a 20 percent discount. Convertible notes often have a cap or limit to the total amount an investor receives at conversion. Caps are different because the investor and company must agree on an estimated company value when the negotiating the loan.

When a company chooses convertible debt, dilution is less because the company value usually goes up. Without setting an initial valuation, investors and companies are generally more fluid in negotiating loan terms. If a business doesn't succeed, debts get paid before equity. Investors like options that are less risky. Companies that don't choose convertible debt spend more money in the beginning.

Investors get some default risk security since bondholders are paid before common stockholders. Companies benefit by raising capital without immediately diluting their shares. Companies may pay lower interest rates on their debt compared to using traditional bonds. Cons Due to the option to convert the bond into common stock, they offer a lower coupon rate.

Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace. Hung convertibles are convertible securities with share prices trading well below the conversion price, making conversion to common stock unlikely. How Contingent Convertibles CoCos Work and the Risks Contingent convertibles CoCos are similar to traditional convertible bonds in that there is a strike price, which is the cost of the stock when the bond converts into stock.

What Are Convertibles? Convertibles are securities, usually bonds or preferred shares, that can be converted into common stock. Convertible Security A convertible security is an investment that can be changed into another form, such as convertible preferred stock that converts to common stock.

Cashless Conversion Definition and Example Cashless conversion is the direct conversion of ownership from one ownership type to another of an underlying asset without any initial cash outlay.

Partner Links. Related Articles. Convertible Notes How is convertible bond valuation different than traditional bond valuation? Stocks Preferred Stocks vs. Bonds: What's the Difference? Investopedia is part of the Dotdash publishing family. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page.

These choices will be signaled globally to our partners and will not affect browsing data. For instance, Shareware offers a handy calculator here where you simply enter an investment amount, discount rate and valuation cap and immediately visualize your conversion value and resulting ownership percentage. FundersClub has some additional numerical examples here , and Cooley GO provides some more hypotheticals and nice graphics here. Of course, once you start adding founders and multiple seed round investors, things can get complicated pretty quickly.

If you need additional help understanding how convertible debt works or looking to raise on a convertible debt, check out LawTrades. Raad Ahmed is an internet entrepreneur and storyteller. We use cookies to ensure that we give you the best experience on our website. By continuing your visit on the website, you consent to the use of the cookies. If you want to find out more about the cookies we use, you can access our Privacy Policy.

The Solution Convertible debt notes were innovated to enable a startup without a valuation to raise capital quickly and less expensively than equity, and as a feasible alternative to obtaining a vanilla bank loan.