What are Convertible Bonds?
Convertibles are a truly unique asset class that is often overlooked by both equity and bond investors. They share many common characteristics with traditional fixed income instruments, including a maturity date, principal repayment at maturity, a fixed coupon payment, and a credit rating. As their name implies, convertibles also include an “option” to convert the bond into the common stock of the underlying company. This combination of fixed income and equity-like characteristics can provide an attractive risk/reward profile for investors.
Investors in convertible securities, barring default, can benefit from a steady income stream and the repayment of principal at maturity, while retaining the option to share in potentially higher equity values. The bond-like characteristics of convertibles provide downside price support, while the embedded equity option provides upside potential. In consideration of this upside potential, investors receive a lower coupon payment on the principal amount of the bond. Therefore, the price behavior of a convertible bond is influenced by both the fixed income value and the common stock price (Chart 1).