What Is a Convertible Bond? A UK Investor’s Guide to How They Work

For UK investors wondering what are convertible bonds and whether they merit attention, this guide covers the mechanics, potential benefits and risks involved. The content here is educational only and does not constitute personalised investment advice.

Convertible Bonds Explained in Simple Terms

A convertible bond starts life as a regular corporate bond. The issuing company borrows money from investors, promising to pay interest (the coupon) at set intervals and return the principal at maturity, subject to the issuer’s ability to pay. So far, identical to standard corporate bonds.

The twist lies in the conversion feature. As a bondholder, you hold an embedded option to convert your bond into a predetermined number of the company’s ordinary shares. You are not obliged to convert. The choice remains yours throughout the conversion period.

Think of it as holding a bond with an attached call option on the company’s shares. If the share price rises significantly, converting may become attractive. If the shares underperform, you can simply hold the bond and collect interest until maturity, assuming the issuer remains solvent.

This dual character is why convertible bonds are called hybrid securities. They blend the income characteristics of bonds with potential upside exposure to the equity market.

How Does Conversion Work?

The conversion process follows specific terms set when the bond is issued. Two figures matter most: the conversion price and the conversion ratio.

Conversion Price and Conversion Ratio

The conversion price is the predetermined share price at which your bond can be exchanged for equity. If a bond has a face value of £1,000 and a conversion price of £20 per share, dividing one by the other gives the conversion ratio: 50 shares per bond.

Conversion Ratio = Face Value ÷ Conversion Price

In this example, if the market share price rises to £25, converting the bond would give you shares worth £1,250, compared to the £1,000 bond face value. However, if the share price sits below £20, conversion would deliver shares worth less than the bond’s face value, making conversion unattractive.

When Can Bondholders Convert?

Conversion windows vary by bond. Some allow conversion at any time during the bond’s life. Others restrict conversion to specific periods or after a certain date. The bond’s prospectus sets out these terms precisely.

Issuers sometimes include call provisions, allowing early redemption; depending on the terms, this may incentivise investors to convert rather than accept redemption.

Why Do Companies Issue Convertible Bonds?

From the issuer’s perspective, convertible bonds offer distinct advantages over standard corporate debt.

The primary attraction is cost. Because investors receive the conversion option as additional value, they typically accept a lower interest rate than they would demand on a straight bond from the same company. This reduces the issuer’s borrowing costs.

For companies expecting their share price to rise, convertibles also offer a way to issue equity at a premium to current prices. If conversion occurs at £20 when the original share price was £15, the company effectively sells shares above where they traded at issuance.

Convertibles may also appeal to companies with limited access to other financing. Younger or higher-risk businesses sometimes find convertible debt more accessible than traditional bond markets or rights issues.

Potential Benefits for Investors

Convertible bonds may offer several potential advantages, though none are guaranteed:

• Income plus equity participation: You receive regular coupon payments while retaining the option to participate in share price gains through conversion.

• Downside buffer: If the share price falls, you still hold a bond paying interest and returning principal at maturity, subject to issuer solvency. This differs from holding shares outright, where the share price can fall substantially (including to zero).

• Portfolio diversification: Convertibles behave differently from pure bonds or pure equities, potentially offering distinct risk-return characteristics within a portfolio.

• Seniority over equity: In a winding-up scenario, bondholders rank ahead of shareholders when claims are settled. However, this does not guarantee recovery; losses remain possible.

These potential benefits must be weighed against material risks, which are covered in the next section.

Risks and Considerations

Convertible bonds carry meaningful risks that every investor should understand before committing capital.

Credit risk: The issuer may default on interest payments or principal repayment. Convertible bond issuers are sometimes smaller or lower-rated companies, which can elevate this risk compared to investment-grade corporate bonds.

Market risk: The conversion feature’s value depends on share price movements. If shares fall or stagnate, the conversion option becomes worthless, and you hold a bond that may yield less than a straight bond from the same issuer.

Interest rate risk: Like all bonds, convertible bond prices move inversely with interest rates. Rising rates typically push bond prices down.

Lower coupon than straight bonds: The embedded option has value, and you pay for it through a reduced coupon. If conversion never makes sense, you have accepted below-market income for nothing.

Dilution: When bondholders convert, new shares are issued, diluting existing shareholders. This matters if you also hold equity in the same company.

Liquidity risk: Some convertible bonds trade infrequently, making them harder to buy or sell at fair prices.

Call risk: Issuer call provisions may force early redemption or conversion at times unfavourable to you.

Convertible bonds carry risks including credit risk, market risk and interest rate risk. They are not suitable for all investors, and share prices can fall below the conversion price, making conversion unprofitable.

Convertible Bonds vs Standard Corporate Bonds

Understanding what corporate bonds are helps clarify where convertibles fit. Standard corporate bonds pay a fixed or floating coupon and return principal at maturity. Your return depends entirely on the bond’s yield and the issuer’s creditworthiness.

What is a bond yield in this context? It represents the return you earn from holding the bond, considering its price and coupon payments. Convertible bonds typically offer lower yields than comparable straight bonds because the conversion option carries value. When comparing, ensure you assess both the income component and the embedded option’s worth.

Convertibles may suit investors seeking some equity exposure while maintaining bond-like characteristics. Standard corporate bonds may suit those prioritising income and simplicity without equity market participation.

Key Points to Remember

What are bonds in investment terms? They are debt instruments where investors lend money to issuers in exchange for interest payments and principal return. Convertible bonds add a layer of complexity through the conversion feature.

Before considering convertible bonds, keep these points in mind:

• Convertibles are hybrid securities combining bond and equity characteristics.

• The conversion option has value, which you pay for through lower coupons.

• Conversion only makes sense when the share price exceeds the conversion price.

• Risks include credit, market, interest rate and liquidity risk.

• Share prices may never reach levels making conversion worthwhile.

• Issuers benefit from lower borrowing costs and potential equity issuance at premium prices.

• These instruments may not suit investors seeking straightforward fixed-income exposure.

This guide provides educational information only. It does not constitute advice on whether convertible bonds are appropriate for your circumstances. If you are uncertain, consider seeking guidance from a qualified financial adviser.