Should you buy convertible bonds?

In the last year there has been a big increase in the amount of convertible bonds being issued by companies across the world. New funds are being set up to invest in them. But should you invest in them right now and what is their resurgence telling us about the outlook for the stockmarket?

What are convertible bonds?

In many ways, convertibles are just like conventional bonds. They pay a fixed amount of interest every year with the promise of returning your original investment at the end of the bond's life. The big difference is that they also offer the investor the opportunity to convert their bonds into shares if the share price goes above a pre-set level before a certain date. This is known as the conversion price.

What do they offer investors?

They offer the relative safety of investing in a bond with the option to profit if the share price goes up a lot. Convertible bonds have often been targeted at more conservative investors who don't want to risk losing money in shares but want a bit more income than is available from savings accounts and government bonds. If the share price goes down a lot then they can usually still collect their bond interest and have their initial investment paid back when the bond matures.

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How they work

The best way to explain this is with a real example. Last year property company British Land issued a five year convertible bond due to be repaid in September 2017. It pays an annual rate of interest on its par (or initial) value of 1.5%, with a conversion price of 693.07p. This price or conversion premium was 31.25% higher than the company's share price at the time the bond was issued. A conversion premium exists to protect existing shareholders from a quick issue of fresh shares that would dilute their interest in the company.

But what do the terms of this bond actually mean in practice?

One answer to this question is to work out the conversion ratio how many shares you can buy with each bond. An investor who buys a bond at £100 can convert it into shares at £6.9307. Another way of looking at this is that the bondwill allow the investor to buy 14.4285 shares per £100 nominal value of bonds (£100/£6.9307). The 31.25% conversion premium means the shares will have to rise by this amount before converting the bond is worthwhile.

How they are valued

The price of a convertible bond depends on the likelihood of it being converted into shares. If conversion is unlikely, it will be valued like a bond. The price will be based on the level of interest rates and the risk of the company defaulting compared with a government bond with a similar remaining life or maturity.

If conversion is likely, the bond price will be closely linked to the company's share price. One way of pricing the bond is to multiply the conversion ratio by the current share price. Currently, British Land's share price is 606p, or 14.4% below the conversion price. This means that conversion is unlikely. The bond price related to the share price would be 14.4285 x 606p, or £87.44. As the current bond price is £110.75, it tells us that the convertible is being valued on it remaining a bond.

Things to look out for

Convertibles are often issued by riskier companies. They offer a conversion option to make the bonds more attractive and to compensate investors for the risks, while allowing them to issue debt at a lower rateof interest than might have been possible. It is useful to ask yourself whether you would still buy the bond if there was no option to convert to shares.

You also need to look at the time remaining before the conversion option expires. How realistic is it that the share price will go up enough to make conversion into shares worthwhile? If income is important to you, then it is a good idea to compare the income you get from the bond and what you might get from the dividend on the shares. Going back to our British Land example, the bond is only paying 1.5%, but a 26p dividend at the 693p conversion price would have a yield of 3.75%. Also remember that, unlike UK gilts, convertible bonds are not exempt from capital gains tax.

Convertible bonds and frothy share prices

While convertible bonds can be a good investment if the terms are attractive enough, they can act as a warning that a company's share price, or share prices in general, are too high. Companies tend to issue convertible bonds when their share prices are high or on an upward trend, so they can tap into the market's enthusiasm for their shares. Could the recent surge in issues suggest the stockmarket is getting frothy?

Recent issues on both sides of the Atlantic could be telling us just that. Internet company Yahoo! recently raised $1.23bn at an interest rate of zero with a conversion price 50% higher than its then share price. Given Yahoo!'s share price has almost doubled over the last year, this hefty premium may suggest investors are overly optimistic about its prospects.

In September, British property company Great Portland Estates issued a five-year convertible bond with a coupon of just 1% and a conversion premium of 35% (equivalent to 714p) and an even bigger premium to its current net asset value per share of 464p.

Cheap debt is usually great news for companies and investors, but when it comes from a low coupon convertible with a big conversion premium, existing shareholders might want to consider selling up.