5 things you should know about Convertible Bonds
“Elon Musk and Twitter, SBF and FTX”. These are probably the most popular pairings in your news feed right now, and you're face-palming at the sheer chaos in the markets.
Well, today we are going to dive into a less-known pairing to emerge out of this chaos,
‘bonds and stocks'. If you’re scratching your head wondering how these seemingly independent things could be related, you’re in for a treat today.
Convertible bonds (or Convertible notes) is a wonderful financial instrument that could function as either a bond or stock. These fixed-income securities initially act as corporate bonds which can be converted into shares of the issuing company.
In this article, we will dive deep into the pros and cons and other aspects you should know before you call yourself an expert in convertibles!
What is a convertible bond?
A convertible bond when first issued acts like a corporate bond. Therefore you are paying for a certificate (bond) which entitles you to annual interest payments and the capital sum upon the maturity of the bond.
However, now you have the right, to convert this bond into shares of the company after the purchase of the bond.
This is different from the government bonds that have made the headlines recently for the soaring yields that they offer. Do check out our full guide to Singapore government securities (SGS bonds) if you are interested in government bonds instead!
Upside potential
Therefore, when the price of the underlying shares increases, the bondholder may choose to convert his/her bonds into shares.
This will allow them to essentially lock in the profits made, by selling the shares at a higher price than the bond price (the price of a stock when the convertibles were bought).
This ‘higher price’, is known as the conversion price. The conversion price is a fixed price stated in the indenture (the contract for a bond), which is a feature in most types of convertibles.
We will discuss this concept in more detail in the next part on convertible premiums.
Conversion premiums
When a convertible bond is purchased for a fixed sum (usually $1000), there will be a ratio indicated called the conversion ratio. This will determine how many shares will be received by the investors when they trigger the conversion.
For example, if the bond is purchased for $1000 and has a conversion price of $50, it means that the conversion ratio will be 1:20. This means that the investor will receive 20 shares for every bond that is converted.
However, investors are not going to convert at the conversion price stated as that doesn't maximise their profits. Hence they will wait till the price of the shares exceeds the conversion price, to convert. The difference between this higher price of the stock and the conversion price is the conversion premium.
Does all of this sound too confusing? Don’t worry, let’s dive into an example of convertibles issued by a very company you might have heard of - Tesla.
Photo by Paul Steuber on Unsplash
Now let’s travel back to 2014, the bottle flip and kendama are the hottest things in town. Yes, that feels like a lifetime ago.
It was here in March 2014 when Tesla, still an unfamiliar brand, issued convertible bonds worth US$2 billion. These convertibles had an interest rate of 1.25% and the maturity would be 7 years later in 2021.
Let’s assume you bought 1 unit of this convertible bond at the 1.25% rate and held it till 2021. In 2014, the stock price of 1 tesla share was around US$14. The $14 here is the bond price of our convertible.
| For simplicity, we will assume that the current stock split ratio was the prevailing ratio since
2014.
The conversion price stated in that bond contract was around US$24.4 (adjusting for the current stock split ratio).
With the conversion price, we can derive that the conversion ratio for a $1000 ($71 after adjustment) convertible then was around 1:3 (71/24.4), since bond value/conversion price = conversion ratio.
In 2021, the stock price has soared to $284 in February 2021. That’s almost a 20-fold increase in the stock price!
Let’s assume you converted your shares at this price (as you should), the difference between the current stock price and the conversion price is about US$259.6. This is the conversion premium that you would enjoy per convertible.
Downside Risk
However, what if the company enters an FTX-like downfall and share prices tumble? Well, that’s the sweet thing about convertibles.
Your downside is well covered as the company is still legally bound to return your capital sum in this case as they would have to for any corporate bond upon its maturity.
The only ‘loss’ that an investor incurs in this case, is the opportunity cost of not purchasing higher-yield corporate bonds instead of convertibles.
If you are thinking of investing in convertibles you might be worried about how much of this downside risk you can take. Fret not as Techiya has the perfect solution — a risk calculator to better know your risk profile.
How to Invest in Convertible Bonds?
ETFs
The recommended way for retail investors like you and me to purchase convertible bonds is through Convertible Bond ETFs.
Some examples of such ETFs from the US are, SPDR Bloomberg Convertible Securities ETF, IShares Convertible Bond ETF etc.
If you’re unsure about how you can invest in ETFs, check out our guide on the 9 best investment apps available in Singapore for you to invest in ETFs.
Portfolio
Another way to invest in convertibles is by owning them as part of a portfolio of different securities.
This is the recommended way of investing in convertible bonds as it helps to limit our downside exposure due to the diversification of the portfolio with many other asset classes.
Therefore, even if the convertible’s underlying stock doesn’t perform well the other securities in the portfolio will most often be able to make up for the potential upside of that convertible.
The portfolio will be allocated with the optimal amount of convertibles so that you can enjoy the maximum upside potential.
Why issue a convertible bond?
Reduce the cost of financing
One of the main reasons a convertible bond is usually issued is to reduce the cost of raising funds.
With traditional bonds, companies which are not yet profitable will have to offer high-interest rates to incentivise investors to purchase their bonds.
Therefore, they incur a high cost in acquiring the funds from the investors due to the high annual interest payout that they have to make. Given the soaring interest rates this year in response to high levels of inflation, this is an even bigger issue for companies.
However with convertible bonds, due to the upside potential of the security, investors will be willing to purchase bonds at a lower interest rate than normal. Therefore companies can acquire funds at a lower cost.
Delay the dilution of equity
Another reason to provide convertibles is to raise funds and delay the dilution of equity.
If a company were to raise funds by selling shares of the company to raise new funds, additional shares would have to be issued. This reduces the percentage of the company that existing shareholders own which is also called dilution of equity.
This would be the preferred choice for companies who expect their income to increase and their share price to consequently rise as well. They will thus be okay with the dilution of their shares in the future.
Types of Convertible Bonds
Vanilla Convertible Bonds
Vanilla convertibles make up most of the convertible bonds available to investors. This convertible entitles the investor the right to convert their bonds to shares when the bond matures, at a conversion price that is fixed in the contract
Mandatory Convertible Bonds
As the name suggests, this convertible makes it compulsory for investors to convert their bonds to shares. This is either at the maturity date or when the company decides to convert their issued bonds into shares
Reversible Convertible Bonds
Reversible convertibles give the issuer the option to either redeem the bonds for cash or convert the bond to shares at the maturity date. This could be an option under mandatory convertible bonds as well.
Companies usually decide to issue such convertibles if they project that, interest rate payments for the bonds will be an issue for their financial health in the future.
Actually, we do have a company close to home that recently made the headlines for redeeming mandatory convertibles. This company is none other than Singapore Airlines.
Singapore Airlines in October 2022, announced that it would be redeeming convertible bonds for S$3.86 billion, as the bonds issued were their "most expensive financing tool, notwithstanding the rising interest rate environment".
Advantages of convertible bonds for Investors
Flexibility
Since convertibles can function as either bonds or stocks, investors have the flexibility to switch between either instrument to maximise their benefits, relative to prevailing market conditions. Therefore, if the share prices were to soar, the investor has the flexibility to convert their bonds to shares to capitalise on the price increase.
Likewise, if the stock price were to drop below the bond price, the investor can hold on to their bonds and continue to receive their interest payments
Guaranteed Payouts
With convertible bonds regardless of most scenarios, the minimum you are assured is your capital sum upon maturity, as well as your annual/bi-annual interest payments.
Therefore bond characteristics of convertibles act as a price floor for the instrument. This is thus the instrument of choice for investors with a low-risk appetite who prefer large potential upsides but limited downsides.
Larger upside potential
As discussed earlier, convertibles will offer a lower yield relative to traditional corporate bonds. However, the upside of convertibles will be able to cover this difference in yields should the underlying shares perform well and provide higher returns.
Priority of repayment upon impending default
If the issuing company is projecting poor financial performance and investors want to write down their investments, convertible bondholders will be paid first before common stockholders.
This protects convertible bondholders from the case where the issuing company goes under and is unable to repay the capital sum assured in the bond contract.
Disadvantages of convertible bonds for Investors
Photo by Emil Kalibradov on Unsplash
Subject to default risks
Just like traditional bonds, convertibles are subject to the risk of the issuing companies defaulting on their interest payments or repayment of the capital funds upon maturity.
Closely tracks both equity markets and interest rates
Although the 2-in-1 combination of stocks and bonds is a blessing in terms of providing limited downside risk, it does come with its complexities.
Since convertibles are affected by both equity markets and interest rates, it is a complex task to monitor both, weigh the trade-offs and make a sound decision. The decisions that most often need to be made are whether to convert the bonds and if yes when to convert them.
Conclusion
We hope this article gives you a greater understanding of how convertible bonds work and their pros and cons.
A convertible bond is a financial instrument not often talked about and is seemingly a foreign concept to most people. Hence if you can understand the points raised in this article you are now an unofficial expert at convertibles!
You’re now probably wondering how you can invest in convertibles or are unsure if you should invest in such instruments given your current financial state. If that’s the case, what you need is a financial advisor to provide the best recommendations for you.
In fact, we are now holding a time-limited free training session to show you how you can achieve 10-15% additional monthly cash flow without monitoring the markets, without analysing charts and without decision fatigue on what to buy and when to sell.
See for yourself how we have helped thousands of others receive up to $10,000 in bonuses as a headstart to their investments, and how they achieve that additional monthly cash flow without overspending time doing it themselves, but in fact, freeing up their time to be able to do the things they really want to do.
If you want to have more time with your family and loved ones or pursue that passion or hobby and even your career without having your assets eaten by inflation, click through this link to attend the training now!
Comments