High interest rates have driven an increase in convertible notes offerings by companies in recent years. Convertible notes contain features of both equity and debt securities. Similar to debt securities, they come with periodic interest payments and have a maturity date. Convertible notes also provide future exposure to the company’s equity. Convertible bonds can be converted into shares of the company’s common stock at a predetermined conversion rate.

The market for new convertible bond issuances has been active in the past couple years. U.S. companies issued more than $40 billion of convertible notes in 2023 and more than $29 billion of convertible notes in 2022. One attractive feature of convertible bonds to corporate issuers is that the periodic interest rate payments tend to be lower than for non-convertible bonds. Investors are instead compensated by the fact that they may receive equity upside in holding convertible bonds.

The conversion rate specifies the number of shares of common stock deliverable for each note. It is one of the most highly negotiated items in a convertible bond offering. The conversion rate is subject to adjustments for corporate events such as dividends and stock splits, providing anti-dilution investor protection. The conversion price is calculated by taking the principal amount of the note and dividing it by the conversion rate.

Conversion of the notes can generally only occur near the maturity date or if certain events occur. A “fundamental change,” such as a change of control of the issuer, will often trigger conversion rights. Additionally, a substantial increase in the company’s share price for many days can provide conversion rights. For example, conversion rights could be triggered if the company’s share price remains above 130% of the conversion price for at least 20 trading days during a 30-day period.

The indentures for convertible notes do not contain many restrictive covenants. This is a distinction from the indentures for high-yield notes, which usually contain a number of restrictive covenants. Convertible notes indentures do come with a variety of ongoing reporting obligations. For example, the issuer may be required to file SEC reports as a result of adjustments to the conversion rate or changes to the conversion conditions.

A corporate issuer will elect a settlement method for its convertible notes. The issuer can choose to deliver cash, stock, or a combination of cash and stock to the holders of the convertible notes. If the issuer delivers only shares upon conversion of the notes, it is known as a full physical settlement. If the issuer delivers only the value of shares in cash upon conversion of the notes, it is known as a cash settlement. There are also more complex settlement methods, referred to as “Instrument X” and “Instrument C.” A full flex settlement, also known as “Instrument X,” provides the issuer with future flexibility to decide between physical settlement, cash settlement, or a combination thereof. Net share settlement, also known as “Instrument C,” requires that the issuer deliver the principal amount of the notes in cash, and then provides the issuer with flexibility to settle the remaining amount in shares, cash, or a combination thereof.

Convertible notes can be issued in a registered offering or through a private placement in reliance on the Rule 144A exemption from registration under the Securities Act of 1933. Private placement transactions using Rule 144A are often a faster method for issuing convertible notes.

Convertible bond issuances can be accompanied by a call spread option. In this type of derivative transaction, the issuer can synthetically increase the conversion price of the notes. The issuer will purchase a call option on its shares at the conversion price. There are two types of call spread structures: (i) a bond hedge combined with warrants or (ii) a capped call. The structuring of the call spread usually depends on intricate accounting considerations.