Convertible Bond

A convertible bond is a debt security that carries a right to exchange it for a stated number of shares of the issuer's common stock. The SEC describes the wider family this way: "A "convertible security" is a security—usually a bond or a preferred stock—that can be converted into a different security—typically shares of the company's common stock. In most cases, the holder of the convertible determines whether and when to convert. In other cases, the company has the right to determine when the conversion occurs." A convertible bond is the debt member of that family; convertible preferred stock is the equity member, and is covered on the preferred stock page. The tax code uses the term itself: IRC 171(b)(1) closes with the sentence "In no case shall the amount of bond premium on a convertible bond include any amount attributable to the conversion features of the bond."

Until conversion, the instrument behaves as a corporate bond: it pays a fixed coupon, it is repaid at face value if it reaches maturity unconverted, and its holder is a creditor rather than an owner. What the conversion right adds is a claim on the stock's appreciation, and what it costs is the price the market charges for that claim, which usually shows up as a coupon lower than the same company's plain bond would pay.

Three numbers describe the conversion right. The conversion ratio is the number of shares one bond converts into. The conversion price is the face value divided by that ratio, the effective price per share the holder pays by giving up the bond. The conversion value (sometimes called parity) is the ratio multiplied by the current share price, meaning what the shares would be worth if the holder converted today. A convertible bond normally trades above its conversion value; the gap, expressed as a percentage of conversion value, is the conversion premium. When the stock is far below the conversion price the bond trades mostly on its value as a bond and the premium is large. As the stock rises through the conversion price the bond's price starts moving with the shares and the premium shrinks.

Who controls the timing. In the ordinary structure the holder holds the option and can wait. The issuer's usual counter is a call feature: once the stock is well above the conversion price, the issuer announces a call, and a holder who would otherwise be paid the call price in cash converts instead, so the call works as a forced conversion. Some issues instead convert automatically on a stated date; those are the cases the SEC has in mind when it says the company may determine when conversion occurs. The prospectus states which structure applies, and it also sets how the ratio adjusts for stock splits and dividends.

Dilution is the cost borne by the existing shareholders. The SEC defines it as "the reduction in earnings per share and proportional ownership that occurs when, for example, holders of convertible securities convert those securities into common stock." It is why a company's diluted earnings per share counts the shares its convertibles could become, a calculation covered on that page rather than here.

The SEC's warning about market-price-based conversion. In a conventional issue the conversion formula is fixed. In some financings, especially by companies that cannot raise money conventionally, the number of shares issued on conversion is set by the market price at the time of conversion, at a discount. The SEC's description of the mechanism is worth quoting: "That means that the lower the stock price, the more shares the company must issue on conversion." More shares mean more dilution, more dilution pushes the price lower, and the cycle repeats, which is why the SEC records that such deals "have colloquially been called "floorless", "toxic," "death spiral," and "ratchet" convertibles." A shareholder of a company that has issued them is exposed to that spiral even without owning the convertible. The SEC directs investors to the company's registration statements, 10-K, 10-Q and 8-K filings on EDGAR to find out whether such a financing exists and how its formula works.

Two tax points are settled at the source. First, Publication 550 states that "You will generally not have a recognized gain or loss if you convert bonds into stock or preferred stock into common stock of the same corporation according to a conversion privilege in the terms of the bond or the preferred stock certificate." Both qualifiers matter: the shares must be the same corporation's, and the exchange must happen under the bond's own conversion privilege. The same publication says that converting a bond into stock of a different corporation generally does produce a recognized gain or loss, absent a reorganization. Second, for a convertible bought above face value, IRC 171(b)(1) excludes the value of the conversion feature from the premium that can be amortized, so the part of the price that bought the option is not written off against the coupon. Bond premium mechanics are covered on their own page.

A company issues bonds with a stated coupon, a maturity date, and a conversion ratio written into the indenture. The holder collects interest and, at any time the terms allow, may surrender the bond and receive the stated number of shares. If the stock never reaches the conversion price, the holder simply keeps collecting interest and is repaid face value at maturity, exactly as with a plain bond of the same issuer. If the stock rises well above the conversion price, the bond's price rises with it, and the holder can sell the bond or convert.

A hypothetical example. Elena buys one convertible bond with a $1,000 face value, a 3 percent coupon, and a conversion ratio of 20 shares. Her conversion price is $1,000 ÷ 20 = $50 per share.

On the day she buys, the stock trades at $40, so the conversion value is 20 × $40 = $800. The bond itself trades at $960, so the conversion premium is ($960 − $800) ÷ $800 = 20 percent. Converting now would turn $960 of bond into $800 of stock, so she holds and collects $30 a year in interest.

Two years later the stock trades at $65. The conversion value is now 20 × $65 = $1,300, and the bond trades close to that figure. Elena can convert and hold 20 shares worth $1,300, or sell the bond for about the same amount. Had she bought 24 shares with the same $960 instead of the bond, they would now be worth 24 × $65 = $1,560, so the bond gave up part of the stock's gain in exchange for the $60 of coupons she collected and the promise of $1,000 back if the stock had fallen instead. That trade-off, less of the upside for a floor and an income stream, is the whole instrument in one example.

If instead the stock had slid to $25, the conversion value would be $500 and irrelevant. Elena's bond would trade on the company's credit, roughly where a 3 percent plain bond of that company would trade, and she would be owed $1,000 at maturity provided the company remained able to pay.

Pros

• Pays a fixed coupon and ranks as debt while the holder waits, so a stock that goes nowhere still produces income and a face-value repayment.
• Participates in the stock's rise once the share price passes the conversion price, without requiring the holder to buy shares up front.
• Conversion into the issuer's own stock under the bond's terms is generally not a taxable event, so the switch from bond to shares does not itself trigger tax.
• For the issuer, the conversion feature lowers the coupon it must pay, which is one reason a company whose stock the market expects to rise may choose the structure.

Cons

• The coupon is typically lower than the same company's plain bond, and the holder gives up part of any large stock gain compared with owning the shares outright.
• A callable convertible can be called once the stock is above the conversion price, forcing the choice between converting and being repaid, at the issuer's chosen moment.
• The debt-like floor is only as good as the issuer's credit. If the company fails, a convertible bondholder is a creditor of a company that cannot pay, and unsecured or subordinated convertibles rank behind senior debt.
• Convertibles with market-price-based conversion formulas can drive the stock into the spiral the SEC describes, harming every shareholder.
• Premium paid for the conversion feature cannot be amortized against the coupon under IRC 171(b)(1), so a buyer above face value gets a smaller tax offset than on a plain premium bond.