In this article, you will learn everything you need to know about convertibles, such as what a convertible is and how to trade convertibles. 

What is a convertible bond?

A convertible bond involves the buyer lending money to the issuer, usually a company, similar to a obligation. But unlike a bond, a convertible bond gives the holder the right to convert the loan into shares in the company, according to specific conditions. The holder can thus choose between getting his capital back at maturity or becoming a shareholder.

A convertible bond can also pay interest during its term, but its main function is the possibility to convert the debt into shares. All convertible bonds have terms and conditions that regulate how and when the conversion can take place. Convertible bonds are often issued as part of a company's capital raising, but are not directly linked to a new issue of shares.

How does trading a convertible bond work? 

An example of trading a convertible bond is as below: 

• Anders buys a convertible bond in a company worth 10 million SEK. The convertible bond serves as a loan to the company, and Anders receives 3 % annual interest on his investment.
• The convertible bond provides an opportunity to convert the value of SEK 10 million into 100,000 shares in the company at a price of SEK 120 per share, if the price at the end of the term is or exceeds SEK 120.
• At the end of the term of the convertible bond, the company has done well. Anders then decides to convert to shares, as he stands to gain the most. The nominal (original) value is SEK 10 million, while the shares are worth SEK 12 million at the time of conversion.

Why do companies use convertible bonds to raise capital? 

Companies use convertible bonds to raise capital to: 

 

• Be able to raise more money without making an immediate new issue and thus avoid direct dilution of shares. The convertible bond initially acts as a loan, which means that the dilution of shareholders' shares only occurs if investors choose to convert into shares at the end of the term.
• Offer investors an interest rate that can often be lower than a traditional bank loan, depending on the company's creditworthiness. For companies with good growth potential, convertible bonds can be a cheaper alternative to other forms of financing.
• Attract investors and venture capitalists by combining interest payments with an option to convert convertible bonds into shares. Investors thus get both security in the form of interest and the potential for value growth if the company does well.

What types of convertible bonds are there? 

Below we explain the most common convertible bonds. 

 

• Classic convertible bonds: These give the holder the right to convert the loan into shares at maturity or at other specified times. Conversion is voluntary and based on the holder's choice.
• Mandatory convertible bonds: These force the investor to convert the loan into shares at the end of the term or if certain conditions are met, for example if the share price reaches a certain level.
• Immediate convertible bonds: These can be converted into shares at any time during the term, giving the holder the flexibility to choose the conversion date.
• Long-term convertible bonds: These have a longer duration, usually between 5 and 10 years, and are often designed for long-term investors. 

In this article, we focus mainly on classic convertibles because they are by far the most common. 

Advantages and disadvantages of convertible bonds for investors

Benefits and advantages

• High flexibility as the owner can choose to either get his capital back or convert his stake into shares at maturity, depending on the terms of the convertible.
• If the company is doing well and the share price increases, the investor can get a higher return on his investment when converting to shares.
• The investor usually receives an interest rate on their loan for the duration, providing some ongoing return, but some convertibles may be interest-free. 

Disadvantages

• The investor takes a credit risk, as the company may not be able to repay the loan in full or at all if it goes bad.
• If the share price falls and does not reach the conversion price during the term, the investor only receives the interest, which is often lower than the average stock market return.

Frequently asked questions

Below we answer frequently asked questions about convertible bonds. 

What is a nominal amount for a convertible bond?

The nominal amount of a convertible bond is the original value of the bond when it was issued by the company. This amount is what will be repaid to the investor if the convertible bond is not converted into shares, and is used as the basis for calculating any interest over the life of the bond. 

What does convertible mean?

A convertible bond is a debt instrument that gives the holder the right to convert the loan into shares in the company at a later date, according to predetermined terms. 

What is included in a convertible bond contract?

A convertible bond contract contains provisions on the amount of the loan, the maturity, the coupon rate (if any), the conversion price, and the terms and timing of the investor's right to convert the loan into shares. The contract may also contain specific restrictions or risk factors related to the conversion. 

Is a convertible bond a good investment? 

A convertible bond can be a good investment for investors looking for a combination of interest and the possibility of share conversion. It offers a potential return through interest and the chance of capital growth if the share price rises, but the risks vary depending on the company's creditworthiness and market performance. Convertibles involve higher risk than bonds but lower risk than direct equity investment, making them suitable for investors seeking a balanced level of risk. 

What is a reverse convertible?

A reverse convertible works in the opposite way to a classic convertible. In a reverse convertible, it is the company that decides whether the convertible will be repaid in cash or in shares at maturity. The investor usually receives a higher interest rate to compensate for the risk that the company may choose to repay in shares, especially if the share price has fallen below a certain level.