convertible bonds

In short

A friend of mine once held a bond that paid him interest every six months and then handed him shares of the company when the stock took off, and he told me it felt like having a seat at the table with a cushion under it. If you are holding a convertible bond or thinking about one, the whole idea fits in a few sentences. A convertible bond is a loan to a company that the lender may swap for a set number of the company's shares. Before anything else, find the conversion price in the bond's offering documents, because that one number drives everything. The company pays a coupon, which is the yearly interest, usually a lower one than a plain bond pays. The lender gives up some interest in return for the right to share in the upside. Read the call terms too, since the company may be able to force a swap or pay the bond off early. Hold on to the paperwork, because the conversion terms sit in the bond's indenture, the legal contract between the company and its lenders.

The whole of it

What it is

I once watched a neighbor lend a young carpenter some money for a new truck. The deal was simple. The carpenter would pay it back with interest, and if his little business ever grew into something big, the neighbor could trade the debt for a small piece of the business instead. That is a convertible bond, dressed in a suit.

A company that issues one is borrowing money. It promises to pay interest on a schedule and to repay the face value, called par, on a set date. Par is the face value printed in the bond's terms, and the offering documents state it for each bond. What sets this bond apart is a built in option. The holder may exchange the bond for a fixed number of common shares. The company does not get to pick that moment. The holder does, unless the contract says otherwise.

You might wonder why a company would offer such a thing. It is a fair question. The answer is that the option has value, and the lender pays for it by accepting a lower coupon. The company saves on interest today. The lender keeps a door open to gain if the stock rises. Both sides get something they want.

How it works

If you are holding one of these bonds, you have probably noticed it behaves like two things at once. Part of it acts like an ordinary bond. It pays interest and it comes due on a date. Part of it acts like a stock option. Its value moves with the company's share price.

Two terms matter most. The conversion ratio is how many shares one bond turns into. The conversion price is par divided by that ratio. So a $1,000 bond with a ratio of 20 has a conversion price of $50 a share. Here is the math with the inputs shown: $1,000 divided by 20 shares is $50 a share.

When the stock trades well below $50, converting makes no sense, and the bond trades mostly on its interest and the company's credit. When the stock climbs well above $50, the bond starts to track the shares, because a holder could swap it for stock worth more than par. That is the cushion and the seat at the table my friend talked about. Falling stock prices tend to be softened by the bond's floor value as a loan. It is a floor, not a promise. If the company fails, the bond can lose value like any debt.

Most convertibles are also callable. That means the company may buy the bond back at a set price after a certain date. If the stock has run up, a call often pushes holders to convert before the company pays them the lower call price. The bond's documents spell out these rules, and the holder has to follow them. The company must give notice, and the notice period is stated in the indenture.

Convertibles are generally unsecured and rank behind a company's senior secured lenders. In a bankruptcy they stand in line after those lenders. Know where you stand in line.

The numbers, and where to find yours

Nobody reads a bond contract for fun, but a few numbers repay the effort. Look for the coupon rate, the maturity date, the conversion ratio or price, the call schedule, and any put right, which lets the holder demand repayment on a certain date. A bond with a put gives the holder a way out that other bonds lack.

The offering document is called a prospectus, or an offering memorandum for private placements. The legal contract is the indenture. For a company that sells securities to the public, these filings go to the U.S. Securities and Exchange Commission, and you can search them for free on its EDGAR database. Your brokerage statement or the bond's page at your broker will also list the coupon and maturity. The conversion terms are in the filings themselves, so go to the source and read the pages on conversion.

On the tax side, converting a bond into shares is generally not treated as a sale under the rules the Internal Revenue Service describes in its publications, though your own facts and any cash paid in place of fractional shares can change the picture. The IRS explains how it treats bond interest and conversions in Publication 550, Investment Income and Expenses. Interest paid on the bond is taxed as income in the year it is paid or accrued. Rates and brackets change by year, so check the IRS page for the current figures rather than trusting a number from memory, including the current figure, which the official source publishes each year.

A worked example

Let me tell you about Dolores, a retired schoolteacher in Ohio. She holds one convertible bond from a mid sized software company. The bond has a par of $1,000, a coupon of 3 percent, and a conversion ratio of 20 shares. The stock trades at $38.

First, her yearly interest. 3 percent of $1,000 is $30 a year, paid as $15 every six months. Next, her conversion price. $1,000 divided by 20 shares is $50 a share. Her stock is at $38, so converting today would hand her 20 shares worth $760, which is 20 shares times $38. That is less than the $1,000 she could collect at maturity, so conversion makes no sense right now. The bond is worth holding as a loan, and she earns her $30 a year while she waits.

Now suppose three years pass and the stock reaches $65. The shares she could receive are worth $1,300, which is 20 shares times $65. That beats par by $300, since $1,300 minus $1,000 is $300. The bond itself would trade near that value or higher, because buyers see the same math. Dolores has two choices on the table. She could convert and own the shares, or sell the bond to another investor. Both are paths the contract allows, and the right one depends on her own goals and taxes, which a tax professional can help sort out.

Compare that to a plain bond from the same company paying 5 percent. That bond pays $50 a year, which is 5 percent of $1,000. Dolores gives up $20 a year in interest, since $50 minus $30 is $20. Over five years that is $100, since $20 times 5 is $100. That $100 is what she paid for the option. The shares must rise enough to beat it. Otherwise the plain bond would have paid her more.

Where it goes wrong

I have seen smart people get tripped up here, and it is never from foolishness. It is from skipping the fine print.

The first trap is the forced call. A company may call the bond when the stock has risen, and the holder must either convert or take the call price. If the holder misses the notice, the choice can be made for her. Calendar those dates the day the bond is bought.

The second trap is dilution. When bonds convert, the company issues new shares, and every existing share owns a slightly smaller slice. Sometimes that is a small effect. Sometimes it is not.

Third, credit risk. A convertible is still a loan to one company. If the firm struggles, the stock falls, the option becomes worthless, and the bond is only as good as the company's ability to repay. These bonds often come from younger or more leveraged companies, so the lender must judge the borrower's strength.

Fourth, thin trading. Some convertibles trade rarely, and the price a seller gets can differ from what the screen shows. Check the spread, which is the gap between what buyers bid and sellers ask.

Last, the tax detail. Some convertibles carry features that create taxable income before cash arrives. The IRS explains original issue discount in Publication 550. Read it before assuming a bond is simple.

Questions to answer before you leave this page

Do you know the conversion price of the bond in front of you, and have you worked out how far the stock must rise before converting beats holding the bond as a loan? Have you found the call date and the notice period, and put them where you will see them? Do you know where the bond ranks if the company falls on hard times, and whether you are comfortable with that spot? What did you give up in coupon compared with a plain bond from the same company, and does the option feel worth that price? Have you looked up the filing on EDGAR and read the conversion section yourself rather than trusting a summary? Is there a put right, and when can you use it? And have you asked a tax professional how interest and any conversion will be taxed in your own situation?