The Best of Both Worlds: Convertible Bonds

Most economics classes often start an investment unit delving into the two basic instruments for purchasing shares in a company: stocks and bonds. However, the financial integration of the two is often left unexplained and therefore untouched by many familiar with the markets. Simplistically dubbed “hybrid securities,” the combination of both debt and equity into one financial instrument, these securities represent an undervalued opportunity for investors and corporations alike.

The most popular hybrid securities are convertible bonds. The basic convertible bond refers to the issuance of a bond by a company. At the discretion of the bond holder, the basic convertible bond can convert into a predetermined number of shares of the issuing company. The final conversion date and the price per share are both settled at the issuance of the bond, among other variables laid out in the prospectus of the offering. But, like most securities, dealmakers can rework changes into the convertible bond before maturation.

In terms of the details of convertible bonds, laying the technical groundwork for understanding convertible bonds is critical to the discussion. Rooted in complex arithmetic, ordinary convertible bonds can be whittled down to several key elements.

The fixed-income portion of the issuance pays a coupon on a principal, similar to other issuances in the fixed income market. In this way, the debt is sensitive to market fluctuations in interest rate and issuer credit rating. In terms of “conversion into equity,” the conversion price refers to the fixed price per share upon conversion, and the “conversion ratio” refers to the number of shares converted. Parity refers to the equivalency between the value of the convertible bond and value of the company’s common stock.

For the issuer, there are a myriad of benefits in convertible bond offerings. The lower coupon rate allows for the corporation to raise capital at a significantly lower financing rate. Additionally, since convertible bonds are appraised at a fee to its parity, the corporation can raise even more capital per share compared to a regular equity issuance. And, most important component to a corporation’s accounting department, there are additional tax breaks in the issuance of convertible bonds. Interest expenses on a convertible bond are tax-deductible, but fund appreciations and dividends paid by issuance of common stock are non-deductible. As a result, the issuance of a convertible bond is a much more tax-friendly method of accumulating capital for a corporation.

Although the lower yields appear to detract from the appeal to the investor, convertible bonds have many alluring qualities for the investor. For instance, one can consider a stock’s performance in a bear market. The stock will almost positively depreciate in value. If the holder hasn’t converted the convertible bond into stock, then they will be experiencing the downside protection of the fixed payments from the bond, rather than undergoing a loss of income due to loss of stock value. On the other hand, in a bull market, the stock will likely appreciate in value. Conversion of the bond into equity shares will result in the investor’s direct participation in that appreciation in value, which ultimately boosts the investor’s prospects on the upside.

Much has changed in the world of convertible bonds since 1874, when Rome, Watertown and Ogdensburg Railroad offered the first ever convertible bond with a maturity of 30 years and a seven percent coupon to finance the construction of a major train line in the United States.

However, the convertible bond market stands strong to this day. In 2014, electric vehicle designer and manufacturer Tesla Inc. issued its largest fixed-income instrument to the public, worth $920 million with a coupon of 0.25 percent, set to mature on March 1st of this year. With a conversion price set at $360 per share, potential for investors looked very bright in early August, with Tesla’s share prices peaking at $380. Unfortunately for investors, volatility and management controversy have driven that price below $300, indicating that conversion will be unlikely amongst bondholders. In this particular case, Tesla will have to pay $920 million to cover the amount outstanding, a less-than-ideal cut into the company’s $3 billion in cash and equivalents.

As for the current state of the converts market, business has been booming. The U.S. convertible market had a market capitalization of $223.6 billion with 475 issues as of June 30, 2018, as reported by Barclays Convertible Market Watch. According to the Trade Reporting and Compliance Engine, the convertible bonds market averages $11.2 billion in convertibles trading per week, indicating extremely highly liquidity. With rising interest rates in the economy, companies are issuing convertibles at a much higher rate to accumulate capital. And since October, the volatile markets make convertible bonds a very enticing option for investors due to the safety of the fixed income with the embedded equity risk.

Between low financing rates and tax breaks for issuers, a safe gamble for investors, and an unpredictable market, convertible bonds present an excellent opportunity for seasoned buyers looking to bolster the portfolio. In a time where mixed predictions about the market are commonplace, placing funds into both stocks and bonds must be an ideal option. As long as markets continue to function, convertible bonds will bring diamonds in the rough for the smart investor.