Convertible Bond

When a company needs money, it has two classic options. It can borrow money and pay it back later with interest. Or it can sell new shares in the company, meaning issue stock. A convertible bond combines both in a single contract. Investors first give the company a loan and receive regular interest payments in return. In addition, they are later allowed to convert this loan into shares at a price set in advance. Whether they do so is up to them — it is a right, not an obligation.

Why companies issue them and investors buy them

For the company, the main advantage is the interest rate. Because the conversion right is attractive to investors, they accept a lower rate of interest. A normal corporate bond might cost the company around five percent interest per year. As a convertible bond, one or two percent is often enough, sometimes even zero. Over several years, that saves a lot of money.

For investors, the convertible bond is a kind of hedged bet. If the share price rises sharply, they convert and earn like a shareholder. If the price falls, they forgo conversion and get their money back at the end of the term. So the potential gain is unlimited on the upside, while the potential loss is limited on the downside. This asymmetry in favor of the investor is really the core of the product.

This isn’t free, however. Anyone who converts increases the number of shares outstanding. This makes the stakes of existing shareholders somewhat smaller. Experts call this dilution. That’s why share prices often react negatively at first to the announcement of a large convertible bond.

Conversion price, maturity, and the math behind it

The contract contains three key figures. First, the face value, i.e. the amount borrowed per unit, often 1,000 euros. Second, the conversion price: the price at which one share is credited upon conversion. Third, the maturity, usually three to seven years.

An example makes this tangible. The share is trading at 100 euros at issuance, and the conversion price is set at 130 euros. For 1,000 euros of face value, one therefore receives around 7.7 shares upon conversion. If the share ends up at 200 euros, these shares are worth about 1,540 euros — significantly more than the 1,000-euro repayment. If, on the other hand, it stands at 90 euros, a conversion would make no sense, and one takes the 1,000 euros instead.

The premium between the current price and the conversion price is called the conversion premium. It is the price the investor pays for the safety net. The higher the premium, the further the share has to rise before conversion becomes worthwhile. Companies are also often allowed to redeem the bond early if the price has stayed above a certain threshold for long enough. This effectively forces conversion and gets rid of the debt.

Where convertible bonds show up in business news

This instrument is especially popular with growing technology companies. They often still make little profit and therefore have a hard time getting affordable loans. At the same time, investors believe strongly in their potential for sharply rising share prices. In precisely this situation, a convertible bond fits well.

A well-known pattern of recent years: companies raise billions through convertible bonds to finance data centers, chips, or acquisitions. Companies that buy large amounts of Bitcoin have also raised money this way. In the news, you then read sentences like: “The company is issuing a one-billion-dollar convertible bond maturing in 2030.”

As a retail investor, one rarely buys individual convertible bonds directly, since the denominations are often large and trading is confusing. However, there are funds that bundle many such securities together. It’s important to distinguish this from a bond with warrants: there, the bond remains outstanding, and the right to shares is traded separately. With a convertible bond, the debt disappears upon conversion.