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Updated May 23, 2022 Reviewed by Reviewed by Thomas BrockThomas J. Brock is a CFA and CPA with more than 20 years of experience in various areas including investing, insurance portfolio management, finance and accounting, personal investment and financial planning advice, and development of educational materials about life insurance and annuities.
Investors have the option of turning convertible bonds into shares of the issuer's common stock at a set price and typically by a set date. The transformation of convertible bonds into shares of stock is usually done at the discretion of the bondholder.
Sometimes, the trigger on a convertible bond is share price performance. In those cases, the bonds convert automatically as soon as the company's stock reaches a set price. Such automatic conversions are a bone of contention among some investors and shareholder advocates.
Issuing convertible bonds can be a flexible financing option for companies. They tend to be more useful for companies with high risk/reward profiles. Such firms often issue convertibles to pay lower interest rates on their debt. Investors will generally accept a lower coupon rate on a convertible bond than an otherwise identical regular bond because of its conversion feature. For example, Amazon.com was able to obtain a 4.75% interest rate on convertible bonds in 1999.
Companies with weak credit ratings that expect their earnings and share prices to grow substantially within a specific time period also tend to favor convertible bonds.
When a company exercises a right to redeem or call a convertible bond, it can force the conversion of convertible bonds to stocks. The bond's prospectus will usually explain the terms of any such forced conversion call feature. A company will often force a conversion when the price of the stock approaches the bond's conversion price. This means the bonds can be retired without requiring any cash payout by the issuer.
The stocks that convertible bondholders get when they convert their bonds come in the form of newly issued securities, which can harm previous investors. In the absence of protections, convertible bonds almost always dilute the ownership percentage of current shareholders.
The result is that stockholders own a smaller piece of the pie after bondholders convert their holdings. For example, Carnival Corp. (CCL) issued some zero-coupon convertible bonds back in 2003 that automatically turned into stock if Carnival's share price hit $33.77. According to the terms of the indenture, convertible bondholders would be allowed to buy the company's stock at $30.70 per share. The bonds did not offer coupons, so investors needed a sweetener. The $3.07 difference between the market price and the conversion price of the bonds provided it. Unfortunately for stockholders who didn't own them, the bonds converted to over 17 million shares. That made for a highly dilutive conversion and negatively impacted existing shareholders.
There is also the possibility that holders of convertible bonds may not want common stock at the time of a forced conversion. For coupon bonds, they could prefer to continue getting an income stream from the coupons. The bondholders might also want to convert to shares at an even higher price.
Forced conversions rarely end to the benefit of the holders of the convertible bond.
What is more, convertible bonds with the best conversion features usually go to investors who already have financing relationships with issuing companies. Some of these features include low conversion prices, preferential conversion ratios, and higher interest rates. Unfortunately, most small investors do not have direct access to these opportunities.