convertible bonds and notes

In short

A friend of mine once lent money to a young company and asked for a stake in return, and neither of us could say quite what he had bought. If you are holding a convertible bond, or thinking about one, the same question may be sitting on your porch. A convertible bond is a loan that pays interest and can be swapped for shares of stock. The company owes you the loan until you swap or it comes due. You get a lower interest rate than a plain bond pays, because the swap right has value. The terms are set in a document called the indenture, and you should read it first. A convertible note is a similar idea used by young private companies. It can behave very differently, so check which one you hold.

The whole of it

What it is

I once watched an old farmer lend his neighbor a few hundred dollars for seed. He asked for no interest. He asked for a share of the first crop instead. That is the heart of a convertible. The lender takes a smaller payment now for a chance at a bigger one later.

A convertible bond is a loan to a company. The company promises to pay interest and to return the principal, which is the original amount lent, on a set date. The bond also gives the holder a right. The holder may trade the bond for a fixed number of the company's shares. Nobody forces that trade. It is the holder's choice, and that is what makes the bond a hybrid, part loan and part stock option.

A convertible note usually means a short term loan to a young private company. It often has no fixed price for the shares. The price gets settled later, when the company raises money from new investors. Notes of this kind often carry a discount or a cap, which are terms that favor the lender. The loan can also come due in cash if no sale of shares happens. The bond and the note share a name and a spirit. Their rules can differ a great deal, so the paper in your hand is what counts.

How it works

If you have ever bought a house with a fixed rate loan, you know a promise on paper shapes everything after. A convertible works the same way. The indenture, which is the contract behind a bond, spells out the rules. The company must pay the stated interest. The company must repay the principal at maturity, the day the loan ends. And the company must honor a conversion if the holder asks for one.

Two terms matter most. The conversion ratio is how many shares one bond turns into. The conversion price is the principal of one bond divided by that ratio. The stock price today sits somewhere below or above the conversion price. If the stock is far below it, the bond acts mostly like a loan. If the stock climbs well above it, the bond acts more like the stock itself.

Many convertibles are also callable, which means the company may buy the bond back early at a set price. When a company makes that call, the holder often has a short window to convert instead. The indenture says exactly how that works. Some bonds also let the holder demand cash back early on certain dates. This is called a put. Not every bond has one.

Here is the part folks tend to miss. Interest on a convertible is taxed as ordinary income in the year it is paid or accrued. A conversion into stock is usually not taxed on the swap itself. The tax comes when the shares are later sold. The rules have details and exceptions, so the Internal Revenue Service publications on bonds and investment income are the place to check, along with a tax professional.

The numbers, and where to find yours

Every figure you need is printed somewhere. For a public bond, the company files a prospectus, which is the formal offering document, with the Securities and Exchange Commission. You can read it free on the SEC's EDGAR database. Look for the coupon, which is the yearly interest rate, the maturity date, the conversion price, and any call or put terms. The indenture is often attached as an exhibit to the filing.

For a private note, the numbers live in the note itself. Look for the interest rate, the maturity date, the discount, and the cap. If you cannot find the conversion terms in plain words, ask the company in writing. A fair issuer will answer.

If you want to know how the tax rules treat your interest, the IRS publishes guides on investment income and on bonds. The limit on any deduction tied to investment interest changes by year, so use the current figure, which the official source publishes each year to check the current rule rather than trusting a number from memory. The SEC's investor education site, Investor.gov, also explains convertible securities in plain language.

A worked example

A neighbor of mine, a retired teacher named Ruth, bought one convertible bond with a face value of $1,000. The coupon was 3 percent. The bond could be converted into 20 shares of stock.

Start with the interest. 3 percent of $1,000 is $30 a year. The company pays that to Ruth whether the stock rises or falls.

Next, the conversion price. $1,000 divided by 20 shares is $50 a share. That is the price at which Ruth effectively buys stock if she converts.

Now suppose the stock trades at $40 a share. Twenty shares at $40 is $800. The bond is worth more as a loan, because $1,000 comes back at maturity. Ruth has no reason to convert.

Suppose instead the stock climbs to $70 a share. Twenty shares at $70 is $1,400. Converting beats waiting for $1,000. The extra value is $1,400 minus $1,000, which is $400.

Compare that with a plain bond. A plain bond from the same company might pay 5 percent. That is $50 a year on $1,000. Ruth's bond pays $30. The gap is $50 minus $30, or $20 a year. She gave up that $20 for the right to convert. Over 10 years, the gap is $20 times 10, which is $200.

So the trade is plain. Ruth gives up $200 over ten years in exchange for a chance at gains if the stock rises. If it never does, she has lost that $200. This is how a convertible works. It is no recommendation for or against one.

Where it goes wrong

I have heard more than one honest person say, "I thought it was safe, because it was a bond." A convertible is still a loan to one company. If the company fails, the holder stands behind secured lenders in line for repayment. A company in trouble can miss its interest payments. That risk is real.

Another trap is dilution. When bonds convert, the company issues new shares. Each existing share then owns a smaller slice of the company. A holder who converts should expect that the stock price may feel pressure.

A third problem is a forced call. If the company calls the bond when the stock is high, the holder must act fast. A missed deadline can mean taking the lower call price in cash instead of the more valuable shares.

Last, private notes often hide their hard parts. A note with no conversion price may turn out to give the lender very little. A note that comes due before the company raises money may leave the lender holding a claim the company cannot pay. The paper decides. Read it.

Questions to answer before you leave this page

Have you found the indenture or the note itself, and read the conversion terms in your own words? Do you know the conversion ratio and the conversion price, and have you worked out what they mean at today's stock price? Can you say when the bond matures and whether the company may call it early? Do you know if the holder has a put, and on which dates? Have you checked the coupon against what a plain bond from the same company would pay, and figured the yearly gap? Do you understand how the interest will be taxed, and have you looked at the IRS guidance or asked a tax professional? And if the company fails, do you know where your claim stands in line?