Convertible bonds (also known as convertible loan note) are a special form of corporate bond: As with a conventional corporate bond, the issuing company pays regular interest (coupon) to the holder of the convertible bond over a fixed period of time. The special feature, however, is that convertible bonds have a conversion right that allows the holder to convert the bonds into shares of the company within a certain period of time at a fixed price and under defined conditions.
The conversion right is usually voluntary. If the investor does not exercise it, he continues to receive the predetermined interest and, at the end of the term, the nominal value of the bond. However, once the investor has decided in favour of the conversion, it can no longer be reversed: This means that the shares cannot be exchanged back into bonds. The exchange can be worthwhile for the investor if the current share price is higher than the agreed conversion price. However, unlike for the bonds, they no longer receive fixed interest payments for the shares. Instead, a dividend payment is possible, although the amount may fluctuate.
Due to the complex investment conditions and the high minimum denominations – sometimes as much as 250.000 euros – convertible bond investment funds are more suitable for private investors than investments in individual convertible bonds.
This is how convertible bond prices behave
Influence of the share price: The closer the company's share price approaches the price at which conversion would be advantageous, the more the price of the bond behaves like the share price. If the share price exceeds the conversion price, the convertible bond increasingly behaves like the share. The share sensitivity – known as the delta in technical jargon – is then typically between 0.50 and 1.00.
Influence of the bond price: In contrast, the price of the convertible bond is almost identical to that of a traditional bond after the share price has fallen far below the conversion price and conversion has become uninteresting for the investor.
Special case of mandatory convertible bonds
In the case of mandatory convertible bonds, the conversion right is not voluntary. They are automatically converted into equities at the end of their maturities. Typically, two conversion prices are defined at the time of issue: one below and one above the current share price. Share fluctuations between these two conversion prices are equalised by adjusting the conversion ratio. If the share price falls, the investor receives more equities on conversion and vice versa. There is no compensation for fluctuations outside these two conversion prices and the convertible bond behaves in a similar way to the equities.
The risk: As the investor does not have the option of returning the mandatory convertible bond at par value, there is no protection against losses.
However, mandatory convertible bonds play a subordinate role and currently account for less than 5% of the total convertible bond universe.
Special case of CoCo bonds
CoCo bond is the abbreviation for contingent convertible bond. With this form of convertible bond, as with mandatory convertible bonds, investors have no say in the conversion. Conversion is linked to a specific event (trigger) that is determined in advance. If this occurs, the convertible bond is automatically converted into equities or written-down. For example, a company's equity ratio falling below a certain level could be defined as a trigger. If the equity ratio falls below the equity limit, the convertible bond is converted into equities and the debt capital is automatically converted into equity. If the event does not occur, no conversion takes place. These bonds are typically issued by banks.
CoCo bonds are not part of the universe and are often explicitly excluded from convertible bond indices.
