How to Buy Convertible Bonds: A Step-by-Step Process

Convertible bonds blend characteristics of debt instruments and equity shares. They offer investors a regular income stream, like traditional bonds, with potential for capital appreciation if the underlying company’s stock performs well. This article explains what convertible bonds are, where to buy them, the steps involved, and key factors to consider before investing.

Understanding the Basics of Convertible Bonds

Convertible bonds function as a hybrid security, incorporating elements of both corporate bonds and common stock. Like a traditional bond, they are debt instruments issued by a company, obligating the issuer to pay periodic interest to the bondholder and return the bond’s face value, or par value, at maturity. The par value for corporate bonds is typically $1,000. Interest payments, known as coupon payments, are commonly made semi-annually, providing a steady income stream to the investor.

The distinguishing feature of a convertible bond is the embedded option allowing the bondholder to convert the bond into a predetermined number of the issuing company’s common stock shares. This conversion right introduces an equity component, offering the potential for capital appreciation if the stock price increases. If the bond is not converted, the investor continues to receive interest payments and the par value at maturity, similar to a regular bond.

The conversion ratio indicates how many shares of common stock an investor will receive for each convertible bond. For instance, a bond with a $1,000 par value and a conversion ratio of 20 means that one bond can be exchanged for 20 shares of the company’s stock. This ratio is determined at the time the bond is issued and is crucial for calculating the conversion price.

The conversion price represents the price per share at which the bond can be converted into common stock. It is calculated by dividing the bond’s par value by the conversion ratio. For example, a $1,000 par value bond with a conversion ratio of 20 shares has a conversion price of $50 ($1,000 / 20 shares). This price is generally set higher than the stock’s market price at the time of issuance, making conversion attractive only if the stock significantly appreciates.

The conversion premium reflects the amount by which the convertible bond’s market price exceeds the current market value of the common stock it can be converted into. It is the extra amount an investor pays for the flexibility and downside protection offered by the bond’s debt features, relative to simply owning the stock. A high conversion premium implies the stock needs to rise considerably before conversion becomes profitable. The bond’s value is influenced by both its debt characteristics (like interest rates and credit quality) and the performance of the underlying stock.

Platforms for Purchasing Convertible Bonds

Individual investors can purchase convertible bonds through various brokerage firms, which serve as primary channels for accessing the bond market. Two common types of brokerage firms facilitate these transactions: online discount brokers and full-service brokers. Online discount brokers generally offer lower fees and provide self-directed trading platforms, suitable for investors who prefer to conduct their own research and execute trades independently. Examples include Charles Schwab, Fidelity Investments, and Interactive Brokers.

Full-service brokers provide more personalized advice, research, and comprehensive financial planning services, often at a higher cost. These firms may be suitable for investors seeking guidance or a more hands-on approach from a financial professional. While some convertible bonds might be available through direct offerings from the issuing company, this is less common for individual retail investors, who primarily access these securities via brokerage platforms.

When selecting a brokerage firm, evaluate several factors. Consider the varying fees associated with bond trading. The availability of research tools, such as bond screeners and analytics, can aid in identifying and evaluating suitable convertible bonds. Customer support and access to a wide range of bond markets are also important considerations.

Steps to Buying Convertible Bonds

The process of buying convertible bonds begins with establishing the necessary investment account. Investors typically need to open and fund a brokerage account that supports bond trading. The account opening process usually involves completing an online application, providing personal identification information such as your Social Security Number, and verifying your identity. Funding the account can be done through various methods, including electronic transfers (ACH), wire transfers, or mailing a check, with funds typically becoming available for trading within one to five business days.

Once the account is funded, the next step involves navigating the brokerage platform to locate convertible bond offerings. Most platforms feature bond screeners or search functions that allow investors to filter available bonds by criteria such as issuer, maturity date, coupon rate, or credit rating. Investors can also search for specific bonds using their CUSIP number, a unique identifier assigned to most securities.

Understanding bond pricing conventions is essential before placing an order. Bonds are generally quoted as a percentage of their par value. For example, a quote of 98.00 means the bond is trading at 98% of its $1,000 par value, or $980, while a quote of 102.00 indicates it is trading at $1,020. When purchasing a bond between interest payment dates, the buyer pays the seller any accrued interest—the portion of the next coupon payment that has accumulated since the last payment date. This accrued interest is added to the bond’s quoted price.

Placing an order requires specifying the bond’s CUSIP or issuer, the desired quantity (typically in multiples of the $1,000 par value), and the order type. For bonds, a limit order is often preferred over a market order. A limit order allows you to specify the maximum price you are willing to pay, providing control over the execution price, which is useful in bond markets where liquidity can be lower than for stocks. After placing the order, the trade typically settles within two business days (T+2), meaning ownership and funds are exchanged by the second business day following the transaction.

Key Considerations When Selecting Convertible Bonds

When evaluating convertible bonds, analyze several factors. The performance and outlook of the underlying stock are important because the equity component significantly influences the bond’s potential for capital appreciation. A stock with strong growth prospects and reasonable volatility can enhance the value of the conversion option, while a declining stock price may diminish its appeal, causing the bond to trade more like a traditional debt instrument.

The financial health and credit quality of the issuing company are also important. This assessment involves reviewing the company’s credit ratings, typically provided by agencies like Standard & Poor’s, Moody’s, and Fitch. A higher credit rating indicates lower default risk, which can provide a greater level of security for the bond’s debt component, ensuring regular interest payments and the return of principal at maturity.

Analyze the conversion premium or discount. The conversion premium reflects the additional cost paid for the conversion option. A high premium suggests the stock needs to rise substantially for the conversion feature to become valuable, potentially limiting immediate upside. Conversely, a bond trading at a discount might offer a more attractive entry point if the underlying stock is expected to appreciate.

The coupon rate and the bond’s yield to maturity (YTM) are also important. The coupon rate defines the fixed interest payments received, while the YTM provides a comprehensive measure of the total return an investor can expect if the bond is held until maturity, considering its current market price, par value, coupon rate, and time to maturity. A higher YTM might compensate for perceived risks, such as lower credit quality or specific bond provisions.

Investors should also examine any call or put provisions embedded within the bond. A call provision grants the issuer the right to redeem the bond before its maturity date, typically at a specified call price. This can limit the bondholder’s potential interest income if interest rates fall and the issuer calls the bond to refinance at a lower rate. Conversely, a put provision gives the bondholder the right to sell the bond back to the issuer at a predetermined price, usually par value, on specified dates. This feature offers protection to investors, allowing them to exit the investment if market conditions deteriorate or if they require liquidity.

Consider the maturity date, when the bond’s principal is repaid. A longer maturity period generally exposes the bond to greater interest rate risk and prolonged equity price fluctuations. Finally, assessing the bond’s liquidity is important. Some convertible bonds, especially those issued by smaller companies or with unique structures, may trade less frequently in the secondary market, potentially making it more challenging to buy or sell them quickly without impacting the price.