What are convertible bonds and when to use them?

Better education about what convertible bonds are, how they work, and their place in a diversified portfolio is needed if advisers and clients are to consider them. 

A convertible bond is a bond with a built-in option allowing the holder to exchange it for a fixed number of shares of the issuing company. This means that the investor has exposure to the upside potential of the issuer’s shares. 

As a corporate bond, convertibles typically have a five-year maturity and pay a coupon.

The coupon is lower than that on a straight bond from the same issuer owing to the valuable option to convert the bond into shares.

If the issuer’s shares do not perform sufficiently over the life of the convertible, the bond is repaid in full by the issuer.  

A convertible bond thus offers elements of both fixed income and equities. The bond component offers protective characteristics, while investors can gain upside exposure from the performance of the underlying equity. 

What are the pros and cons of convertible bonds?

Like any investment, convertible bonds have both positives and negatives. 

Investors have access to long-term optionality on the underlying equity but with limited downside risk, as this is protected by the nominal value of the bond.

The upside potential is in principle unlimited, although in certain circumstances if the shares perform very well the issuer can oblige holders to convert early. 

This upside potential explains why investors accept a lower coupon than a straight bond from the same issuer.

Most convertible bonds rank equally with other straight debt issued by the same issuer, with convertible bond default rates considerably lower than in the high-yield market.  

The blend of equity upside potential with bond cash flows gives investors an asymmetric return profile.

Known as convexity, investors would typically expect to participate more on the upside than what they lose on the downside. 

The appeal of convertible bonds for growth companies means convertible investors gain exposure to secular themes like AI.

On the negative side, as the valuable equity option is offset by a lower coupon, convertibles are not typically considered as a yield instrument.

As with any bond, repayment at maturity depends on the creditworthiness of that issuer.

The convertible bond market is relatively niche so large institutions can only allocate a relatively small percentage of its total investments.

While the market has a wide array of issuers, mega-cap companies like Apple and Alphabet tend not to issue convertibles, although Amazon, Tesla and Nvidia have all used convertibles in the past.

What sort of companies finance through convertible bonds?

Growth companies – companies in sectors such as IT, healthcare, and e-commerce – have been particularly active in issuing convertible bonds in recent years. 

Fast growing and cyclical companies can finance ambitious growth strategies comparatively cheaply due to the coupon savings relative to issuing straight debt. 

However, in recent months, more traditional and value companies have been tapping the convertible bond market.