What are convertible bonds and how do they work? Risks and benefits

Convertible bonds are “hybrid” financial instruments, capable of combining the characteristics of corporate bonds with the peculiarities of the shares of a listed company.

Investors can find in this particular asset class the typical defensive coverage of the return if the stock market is falling, or take advantage of the rises of the shares during a bull market.

In a year - 2025 - that promises to be full of pitfalls and challenges in the wake of what happened in 2024, between geopolitical uncertainties, wars, trade tensions, wavering economic growth forecasts, the danger of AI and crypto bubbles and the unknown on the Fed and ECB rate policy, knowing all the investment options is truly fundamental.

To build a portfolio that is proof against financial shocks, therefore, convertible bonds can be a valid opportunity for coverage and earnings. What are they, how do they work and what are the risks and benefits for those who decide to buy these financial instruments.

What are convertible bonds? The characteristics

Convertible bonds are so called because they allow holders to transform their bonds into shares at certain deadlines.

This peculiarity classifies them in a intermediate position between bonds and shares. In summary, convertible bonds are:

corporate bonds with a coupon payment (fixed or variable coupon) that offer an option to purchase shares of the issuing company or a third-party company.

Through convertible bonds, the saver can therefore decide, at a certain date, whether to transform the bond in possession into share title, thus assuming the status of member, or wait for the maturity date and obtain repayment of the credit.

What are the characteristics of convertible bonds

The elements that characterize convertible bonds are:

• possibility of conversion: in the case of conversion of bonds into shares, these are generally ordinary shares and more rarely savings. It is also necessary to distinguish between:
  • direct conversion (when the shares are issued by the same company that issued the initial bonds);
  • indirect conversion (when the underlying share is issued by another company);
• conversion ratio: that is, the number of shares assigned for each of the converted bonds. This conversion ratio is always fixed, which means that it is independent of the market value of both the initial bond and the share into which it is converted. In general, the conversion ratio is fixed at 1:1;
• conversion period: the period of time in which the saver has the possibility of converting his bonds into shares.

These bonds usually offer lower coupons than traditional bonds. Furthermore, precisely because these debt securities offer an additional right to their holders (that of conversion into shares), they cost more than a bond (with the same maturity
and the same coupon) issued by the same company.

How do convertible bonds work?

When an investor buys corporate bonds, in general, he is making a loan to the company that issued the debt on the market through the bond.

The interest paid periodically through the detachment of coupons is the investor’s remuneration. Convertible bonds also offer these payments, through the disbursement of generally lower and less convenient interests.

However, the investor has the possibility of obtaining a further gain by converting the bonds into shares, if these have increased in value.

The securities obtainable from the conversion of convertible loans are generally represented by ordinary shares, more rarely savings shares, of the same company that issued the convertible bond. This is the case of direct conversion. indirect conversion, on the other hand, occurs if the underlying share is issued by another company.

“conversion ratio” refers to the number of shares assigned for each bond that is converted. Very often the conversion ratio is set at 1: 1, one share for each bond converted. The conversion ratio is fixed: it is independent of the market value of one or the other security at the time of conversion.

The conversion period is represented by those time intervals in which the bondholder has the right to convert the bonds.

When is it convenient to convert a bond into a share? An example

The holder of a convertible bond has the right to decide whether to transform the bond into a share according to a pre-established price.

If the price of the stock is increasing, exceeding the price to be paid to convert the bond, it is profitable to choose this option. With the conversion, in fact, you can buy the stock at a lower price than the one on the stock exchange.

Let’s take an example. A company issues a convertible bond with a nominal value of 200 euros and a conversion ratio of 1/3 (possibility of obtaining one share for every 3 bonds owned).

To calculate the conversion price, how much you actually pay to have a share, you divide the nominal value of the bond by the conversion ratio, i.e. 100/0.3 = 333 euros.

If the market price of the stock exceeds the conversion price, then it is convenient to convert the bond.

Advantages and risks of convertible bonds

The issuance of convertible bonds by a company represents a positive signal for the market, as it implies that the company’s management expects positive performance by the company and an increase in the price of the shares.

Convertible bonds provide the saver with a series of advantages compared to common bond or equity investments, such as:

• the repayment priority recognized for this type of securities compared to shares in the event of bankruptcy of the issuing company;
• protection from falls in the shares underlying the security;
• advantage in the event of a rise in the stock price, by exercising the conversion right or directly selling the convertible bond at a higher price than the one at which it was purchased;
• reduction of the effects of volatility in phases of market turbulence
  thanks to the low duration that characterizes these bonds.

The main disadvantage of convertible bonds occurs in the event of stock market declines or simultaneous declines in the bond and stock market: these eventualities would make the conversion into shares of the security disadvantageous and, at the same time, would ensure lower returns than those obtainable from an ordinary bond.

It should also be remembered that the coupons detached from a convertible bond are generally lower than those of ordinary bonds.

Safeguards for convertible bonds

The company that issues convertible bonds must obtain the consent of the extraordinary meeting, after having paid up the existing capital in full, so that the shares are released.

The reason is that, at the same time as the issue of such bonds, a capital increase must also be resolved in order to give the bond holders the opportunity to subscribe to the shares if they decide.

As a further protection for the holders of convertible bonds, art. 2420 bis establishes that, if the terms set for the conversion have not expired, the company cannot resolve either the reduction of excess capital or the modification of the provisions of the articles of association concerning the distribution of profits, unless the holders of such bonds are given the option to exercise the right to conversion within a certain time.

Original article published on Money.it Italy. Original title: Cosa sono le obbligazioni convertibili e come funzionano? Rischi e vantaggi