A convertible bond is a hybrid security that acts like a traditional bond until it is converted into equity in the issuing company according to the terms of the bond.

Example of Convertible Bonds

A company issues a $1,000 10-year bond paying 4% annual interest that can be converted into shares in the company at any time at the rate of 100 shares per bond.

Over the life of the convertible bond, the bond-owner has an incentive to convert the bond into shares any time the share price is over $10 per share, as this would increase the face value of his principal while losing access to the 4% interest payment.

In this example, on the 9th year of the bond the share price reaches $11 per share. The bondholder chooses to exercise his convertible bond, as the 10% increase in the face value of his bond outweighs the two 4% interest payments he would receive at the end of the 9th and 10th years of the bond.

Reasons for Issuing Convertible Bonds

Convertible bonds can be issued for a wide variety of reasons.

Convertible bonds are often issued when there is a concern about default risk and the systemic importance of the issuing company. Convertible bonds help to avoid lengthy legal battles in the cases of defaults and bankruptcies, which allows for the comparatively smooth continuation of operations for the issuing company.

Therefore, convertible bonds are particularly popular among systemically-important financial firms, such as banks and insurers, particularly ones that have had issues with defaults and bankruptcy proceedings in the past.

Another reason to issue convertible bonds is to create a sense of confidence for debt holders of young companies. While young companies may have problems making loan repayments early in their life, the value of their shares are much likelier to rise compared to more established companies. Therefore, the convertible bonds of young companies offer a potential increase in value that compensates for their higher default risk.

Generally convertible bonds offer added value for investors, which decreases the cost of raising capital and maintains a positive market interpretation of a company’s corporate finances and future prospects.

Trading Convertible Bonds

The value of convertible bonds are closely tracked by debt investment firms, so the likelihood of a day trader finding easy arbitrage trading opportunities are low. However, as convertible bonds reach one or more thresholds where their value can swing dramatically, such as an exercise date or interest payment date, then convertible bonds will display price action that day traders are well-positioned to profit from.

Finding and tracking a large number of convertible bonds can be a great way to generate a significant list of potential securities to trade. Every time that one of these tracked convertible bonds reaches a significant threshold in value, the day trader can start observing the price action, looking for an opportunity to trade.

Day traders who trade in convertible bonds should be cautious, however, as the volume traded for convertible bonds can be quite low, particularity in the case of convertible bonds that have fallen below some value threshold. This means that the day trader may end up holding convertible bonds for an extended period or being forced to sell them at a steep discount.

Final Thoughts

Convertible bonds are a part of the relatively new trend in hybrid securities that combine favorable features from multiple asset classes. Convertible bonds in particular offer a balance of security in the form of traditional bond interest and principal payments combined with the potential upside of conversion to equity if the price of the shares reaches a value threshold.

The conversion to equity can also act as a form of security for risky bonds, as this allows bondholders a quick and simple source of value instead of being trapped in lengthy legal proceedings over default and bankruptcy matters.

Day traders will find that convertible bonds can offer the kind of price action that responds well to traditional technical analysis techniques. However, they should be aware that trading volumes for convertible bonds can be low, particularly when some key value threshold is not reached or is reached yet not maintained. Day traders should also be sure that they fully understand the specifics around the conversion from debt to equity, as they can be quite complex.