Most investments fall into one of two camps. Bonds pay regular interest and give your money back at the end. Shares give you a slice of the company and its future growth. A convertible bond sits in between: it starts life as a bond but can be swapped for shares. Companies issue them in large numbers, especially when they need money quickly, so it helps to understand how they work.
What a convertible bond is
A convertible bond is a loan to a company that pays interest, known as the coupon, and has a set maturity date when the company must repay the face value. The twist is that the holder has the right to convert the bond into a fixed number of the company’s shares instead of being repaid in cash.
The number of shares received is set by the conversion ratio, and the share price at which conversion makes sense is called the conversion price. That price is usually set well above the share price on the day the bond is issued, often 20 to 40 per cent higher. The difference is the conversion premium.
A simple example
Imagine a company’s shares trade at £10. It issues a convertible bond with a conversion price of £13. If the shares rise to £18, bondholders can convert and receive shares worth far more than the face value of the bond. If the shares never get above £13, holders simply keep the bond, collect the interest and get their money back at maturity, assuming the company can pay.
Why companies issue them
Because investors get the option to share in future gains, they accept a lower interest rate than on a normal bond. That makes convertibles a cheaper way for companies to borrow, which is attractive when interest rates are high. They are particularly popular with fast-growing technology companies and with firms that want to raise money without issuing shares immediately at today’s price.
Why investors buy them
For investors, the appeal is a mix of protection and upside. If the shares do well, the bond rises with them. If the shares fall, the bond’s value is supported by its interest and repayment, so it usually falls less than the shares. That balance is why convertibles are sometimes described as offering a cushion with a kicker. Specialist hedge funds also trade them, often buying the bond and selling the shares short to profit from mispricing.
What it means for existing shareholders
Convertibles can matter a great deal to ordinary shareholders. If bonds are converted, new shares are created and existing holders own a smaller slice of the company. That is dilution, and our guide to share dilution explains it. It is also common for a company’s shares to fall on the day it announces a convertible issue, partly because of that future dilution and partly because hedge funds sell shares to hedge their new bonds.
The risks
A convertible is still a loan, so it carries credit risk. If the company runs into trouble, the share option becomes worthless and bondholders depend on getting their money back. Companies that rely heavily on convertible debt can face a wall of repayments if their shares fall and holders choose not to convert. Higher interest rates can also make refinancing that debt more expensive. Our explainer on gearing ratios covers how to judge debt levels.
The bottom line
Convertible bonds blend lending and ownership, offering investors interest plus the chance to share in rising share prices, and giving companies cheaper funding. For shareholders, they are worth watching because they can lead to dilution and short-term pressure on the share price. If you want a clearer view of how well you weigh risk and reward, take the free Samuel & Co Trading Trader Assessment.
