5 Disadvantages of Convertible Bonds

Convertible bonds represent a unique type of debt security that combines characteristics of both traditional bonds and stocks. Essentially, a convertible bond is a bond that can be converted into a predetermined number of common shares of the issuing company, typically at the holder’s discretion, but subject to specific terms and conditions outlined at the time of issuance. For companies, this form of financing provides a way to raise capital while offering investors the opportunity to benefit from the potential upside of owning stock in the future.

While convertible bonds can provide attractive benefits for both issuers and investors, they also come with certain drawbacks and risks that both parties must consider.

Below are the risks and drawbacks that come with convertible bonds:

1. Riskier for Investors: Priority in Bankruptcy

One of the primary risks associated with convertible bonds is that, in the event of bankruptcy, bondholders may have a lower priority claim on the company's assets compared to secured debt holders. When a company faces financial distress or liquidation, secured creditors (those with collateral backing their debt) are paid first. Convertible bondholders, on the other hand, are considered unsecured creditors, meaning they are typically lower in the payment hierarchy after the secured debt has been cleared.

In bankruptcy proceedings, if the company does not have sufficient assets to cover the claims of secured creditors, there may be little to nothing left for convertible bondholders. This is a significant disadvantage for investors because, unlike stockholders, they do not have the same residual claim to a company's equity after all debts have been paid. Therefore, the potential for loss is higher in a convertible bond investment compared to other secured forms of debt.

This risk is especially relevant in volatile industries or with companies that are financially unstable, where the possibility of bankruptcy is a real concern. Investors must weigh the risk of bankruptcy and the likelihood of receiving payment on the bond in case of default. While the conversion feature provides the potential for upside if the company performs well, the bondholder is still exposed to the risks associated with the company’s solvency.

2. Premium Over Current Stock Price

Convertible bonds are typically priced at a premium to the current market price of the underlying stock. This means that, at the time of issuance, the bond is sold for more than the value of the stock it could eventually be converted into. This premium arises because of the value of the option to convert the bond into shares at a future date, which provides investors with potential upside if the company’s stock price rises over time.

However, this pricing mechanism creates a challenge for the bondholder. In order for the conversion to be worthwhile, the company’s stock price must appreciate significantly over time. For instance, if an investor purchases a convertible bond and the stock does not perform well, or if the stock price remains flat, the investor may not be able to convert the bond into shares at a price that provides any meaningful profit. Essentially, investors must wait for the stock to reach the conversion price before making the conversion effective, and if that does not occur, they are left with a bond that might yield lower returns compared to other, non-convertible debt options.

This constraint can be particularly frustrating for investors who are holding onto the bond for the potential stock upside, only to see the stock fail to rise to the necessary levels for conversion. As a result, the convertible bond ends up behaving more like a regular bond, providing only fixed coupon payments without offering any potential for capital appreciation.

3. Lower Yield Compared to Non-Convertible Bonds

One of the most significant drawbacks of convertible bonds is that they typically offer a lower yield to maturity compared to traditional non-convertible bonds. Because the convertible bond includes the option to convert it into stock, the issuer can offer a lower interest rate. This lower yield is compensated for by the potential upside of converting the bond into stock if the company’s share price increases.

While this may seem attractive to investors who are bullish on the company’s future stock performance, it can be frustrating for those who are seeking higher guaranteed returns. A traditional bond with a higher yield provides more predictable income, especially in a low-interest-rate environment. Convertible bonds, on the other hand, offer reduced income stability, as the yield is lower, and the potential for capital gains depends on the performance of the stock, which is not always guaranteed.

For investors who are seeking reliable, steady income from their investments, convertible bonds may not be the best choice due to their lower yield and reliance on stock price movements. In addition, the potential capital appreciation offered by the conversion option may not materialize if the company’s stock price fails to rise.

4. Complexity and Confusion

Convertible bonds are more complex than traditional bonds, and this complexity can be a barrier for some investors. While they combine the characteristics of both bonds and stocks, convertible bonds can be difficult to understand in terms of how they work and how to evaluate their potential for return.

Investors need to consider several factors when evaluating convertible bonds, including the conversion price, the coupon rate, the maturity date, the current stock price, and the volatility of the underlying stock. In addition, they must assess the likelihood that the company’s stock will appreciate to the point where converting the bond becomes profitable. These variables make convertible bonds more difficult to analyze and predict than traditional debt securities, which simply provide periodic interest payments and a known repayment date.

For investors who are not familiar with the nuances of convertible bonds, making decisions about whether to hold, convert, or sell the bond can be confusing. Furthermore, these bonds may require more active management and monitoring to ensure that they are performing as expected, and that conversion remains an attractive option. This added layer of complexity can be a drawback for individual investors who are looking for simpler, more straightforward investments.

5. Dilution of Earnings Per Share and Control

For the issuing company, offering convertible bonds can be an attractive way to raise capital, especially during periods of low interest rates or financial stress. However, this method of financing comes with significant drawbacks as well, particularly related to the dilution of the company’s existing shareholders.

When convertible bonds are converted into stock, the company’s total number of outstanding shares increases, which dilutes the value of existing shares. This dilution impacts earnings per share (EPS), which can lower the profitability indicators used by analysts and investors to evaluate the company’s performance. As a result, shareholders may see a decline in the value of their holdings, as the company’s earnings are now spread over a larger number of shares.

Additionally, the conversion of bonds into equity can dilute the control of existing shareholders, particularly in closely held companies. As new shares are issued, the relative voting power of the current shareholders is reduced, which could result in a shift in decision-making power within the company. This can be particularly concerning for founders or major shareholders who wish to maintain control over the direction of the business.

Next: Advantages of Convertible Bond Issue