Convertible notes

Convertible notes are bonds or notes issued by a company that pay interest and can be converted into the company's common stock (or cash, or a combination) at a predetermined conversion price. Investors get downside protection from the debt with upside if the stock rises.

How it works

The key terms are the coupon, maturity and conversion rate, stated as shares per $1,000 of principal. The conversion price, $1,000 divided by the conversion rate, is usually set at a premium to the share price at issue, commonly 20% to 40% for larger issuers. Because of the embedded option, the coupon is lower than on straight debt. Larger issuers typically sell converts in Rule 144A offerings to institutional buyers; many pair them with a capped call, a hedge that raises the effective conversion price and reduces dilution.

In microcaps, "convertible notes" often means something very different: toxic or floating-price notes that convert at a discount to the recent market price. These can lead to heavy, repeated dilution as the price falls.

Why it matters for traders

Stocks often drop on a convertible offering announcement. Part of that is dilution risk, and part is hedging: convertible arbitrage funds buy the notes and short the stock to hedge, creating selling pressure at pricing. Watch the conversion premium, the size relative to market cap, whether there is a capped call, and whether proceeds are used to repurchase shares concurrently. For microcaps, a floating conversion price is a major warning sign.

Example

Hypothetical Northwind Software (NWSW) trades at $50 and issues $500 million of 1% convertible notes due in five years with a conversion price of $65, a 30% premium. The conversion rate is $1,000 / $65, or about 15.38 shares per note, so full conversion would create about 7.7 million new shares. NWSW falls 6% on the announcement as hedge funds short shares against the notes.

FAQ

Are convertible notes dilutive?

Potentially. If converted into stock, they add shares. Diluted EPS includes the effect of conversion when it reduces EPS.

Why does a stock fall when a company issues convertible notes?

Investors weigh future dilution, and convertible arbitrage funds short the stock to hedge their purchase of the notes.