Convertible bonds, also known as exchangeable bonds, are classified as a type of Hybrid investment because they possess characteristics that are bond-like while at the same time their specific features give them a connection to Equity or Growth investments. For example, just as with a regular bond, a convertible bond will provide the investor with a guaranteed annual rate of interest income and a maturity date upon which the issuer guarantees to return the investor's capital. However, unlike a regular bond, a convertible bond contains a special feature that enables the bond to be converted into another form of investment (including common shares, preferred shares or another bond of the issuer).
The bond's Conversion/Exchange feature will enable the bondholder, and possibly the issuing corporation, the right to convert the bonds into shares of another class (such as common shares). The conversion privilege will specify the share type, the conversion price, and the specific conversion date or period. The value of the conversion privilege will depend upon the value of the underlying shares, the conversion ratio, and the length of the conversion period.
A Conversion feature embedded in a bond will enable the bondholder or the issuer to convert the bond investment into a specified number of common shares of the issuer. By exercising the bond's conversion feature, the investment would change its type from Debt (bond) investment into an Equity (common shares) investment.
An Exchange feature enables the issuer or bondholder to convert the bond into another series of bond or into a new class of preferred share. The exchange feature simply changes the “Debt” capital into another form of “Debt” capital.
Example of a Conversion feature, converting the bond into the issuer’s common shares:
Convertible: Convertible until December 31, 2012 or one business day prior to the date fixed for Redemption, whichever is earlier, into 27.7778 common shares per $1,000 face/par value of the bond. This is a conversion price per common share of $36.00.
Example of an Exchange feature, converting the bond into another bond:
Exchange: Exchangeable on a minimum of 30 days notice on April 30 and October 31 of each year into an equal amount of new bonds. Exchangeable by the bondholder, only after notice from the issuer, for an equal aggregate principal amount of new bonds. The material attributes of the new bonds will be the same as those of the issue exchanged, except that the new bonds will rank senior and equally with the other deposit liabilities of the issuer and will include events of default related to default in the payment of interest due thereon.
Example of an Exchange feature, converting the bond into preferred shares:
Exchange: Exchangeable into 40.00 first preference shares, Series 1, of the issuer, per $1,000 face/par value of the bond. This represents an exchange price per first preference share, Series 1, of $25.00.The first preference, Series 1, shares will pay semi-annual non-cumulative dividends equal to $0.50 per share.
Note: Unlike other types of bonds and debentures, convertible bonds do not trade in the secondary bond market, but rather convertible bonds are given a stock market symbol and they trade on the Toronto Stock Exchange (TSX). For example, Penn West Energy Trust has issued a number of convertible bonds, of which one of these trades on the TSX under the symbol PWT.DB.D. In 2010, corporations had approximately 195 convertible bond issues outstanding and trading.
Note: With regard to taxation, usually the investor’s bond book value is carried over to the new share class/type. In some instances the conversion can trigger a taxable disposition of the original bonds. An investor should consult with their income tax consultant prior to any conversion action.
Below is a link to a great discussion of convertible bonds published by Scotia McLeod. Even though this article was written in March, 2009, the information will help expand your understanding of convertible bonds.
Click here to view Scotia McLeod's Introduction to Convertible Debentures