After I read some articles on convertible debt, I have gained a lot of confusion. When the company (who issues the debt) is doing well, it's kind of like options. But when the company is doing bad, the bond has zero ability to remove its risk.

Say if I invest some money in a company and it's doing poorly, why should I need its shares? The stock of a falling company is worth nothing.

  • It removes some risk compared to stocks, not compared to normal bonds. – JB Chouinard Jul 18 '19 at 15:46

If a company is doing poorly today, that doesn't mean it will do poorly tomorrow.

Convertible debt, since it is debt today, creates the legal requirement to pay principal, and usually also the requirement to pay periodic interest. If bankruptcy occurs, you may get some value back, as assets of the business are sold to satisfy the creditors (which includes you).

Since the company could do well in the future, wouldn't it also be nice to gain a proportionate amount of that equity growth, at your own choosing?

When compared with a simple bond, Convertible debt doesn't reduce the holder's risk, it increases the holder's possible return. When compared with simple share ownership, it reduces risk, because of the legal protections granted to creditors.

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Your confusion is that you would get stock of a falling company. The point of convertible debt is that you get money if the stock doesn't perform and you get stock if it's above a certain threshold.

The reduction of risk occurs because you get your money back plus specified interest, at the very least (unless that company ends up in bankruptcy before the debt payment is due).

Only if the company stock is above a certain threshold, which would give you far more profit than interest would, you get stock.

There is no "why would I want stock of a falling company" because you'd just get money.

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    Note that bond holders might very well get money back in bankruptcy, even if it's only pennies on the dollar. – RonJohn Jul 18 '19 at 17:24

Technically, convertibility doesn't remove risk, and if you have a source that says it does, I would like a cite (convertible bonds are less risky than stock, but are more risky than regular bonds). However, it does address a possible source of regret: if the stock shoots up, then with a normal bond you've invested money into the company and aren't getting any of the added benefit. Psychologically, for many people this feels like they've "lost" something by buying the bond rather than stock. So a convertible bond is a way for people to get the safety of a bond without having the FOMO.

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