What it means
The defining feature is that you hold a security with debt-like characteristics, such as a coupon and a maturity date, but the amount you eventually receive depends on how an equity performs. That linkage can be gentle, as with a convertible bond that only becomes equity if the share price does well, or aggressive, as with a reverse convertible that hands you shares when the price falls.
Issuers like these instruments because the embedded equity feature lets them borrow more cheaply than they otherwise could. A company issuing a convertible bond might pay a 2% coupon where a straight bond would have cost 6%, in exchange for giving bondholders the right to convert into shares at a premium.
Investors like them for the shape of the return rather than the size. A convertible offers downside cushioning from the bond floor with participation in the upside, while a reverse convertible offers a high coupon in exchange for taking on the risk of a sharp fall in the reference share.
The nuance that trips people up is direction. Some equity-linked securities reward you when the share rises, and others pay a fat coupon precisely because you are the one absorbing the downside, so reading which way the linkage runs is the first job with any new instrument.
Valuation is genuinely technical, because the price combines a bond component with one or more options. Small changes in expected volatility, dividends or interest rates can move the value noticeably even when the underlying share price has not moved at all.
In practice
Real-world examples.
Example
A fast-growing biotechnology company issues a five-year convertible bond with a 1.5% coupon rather than borrowing at 7%, because investors accept the low income in return for the right to convert at a 30% premium to the current share price.
Example
An income-focused investor buys a reverse convertible on a large utility share to earn a 9% coupon, accepting that a fall of more than 25% will leave them holding the shares at a loss.
Example
A corporate treasurer holds mandatory convertible preferred shares issued by a supplier, knowing the holding will automatically become ordinary shares in three years and planning the accounting treatment in advance.
Formula
Calculation
For a reverse convertible: Payout = Coupon + Principal if the reference share stays above the barrier; Payout = Coupon + (Principal / Initial share price) x Final share price if it does not.
An investor puts $10,000 into a one-year reverse convertible linked to a share priced at $50.00, paying a 10% coupon with a barrier at 70% of the starting price, which is $35.00.
Coupon received either way: $10,000 x 10% = $1,000.
If the share finishes at $46.00, it never breached $35.00, so the investor receives $10,000 of principal plus the $1,000 coupon, a total of $11,000.
If the share finishes at $30.00, below the barrier, the investor receives shares instead. The delivery is $10,000 / $50.00 = 200 shares, worth 200 x $30.00 = $6,000, plus the $1,000 coupon, a total of $7,000 and a loss of $3,000.Case study
Seen in the real world.
This illustrative and fictional example follows Marrowfield Capital, an invented family investment office managing $40,000,000. Looking for income without buying more ordinary shares outright, it invested $250,000 in a three-year mandatory convertible paying a 7% coupon, issued by a listed packaging group.
The security paid $250,000 x 7% = $17,500 each year, giving $52,500 of coupons across the three years, and then converted automatically into ordinary shares at maturity. Because conversion was mandatory rather than optional, Marrowfield ended up holding equity regardless of where the share price stood on the conversion date.
The office's investment committee treated the episode as a useful reminder in its illustrative internal notes. The coupon had been attractive, but the instrument was never a bond in substance, and it should have been sized against the equity allocation rather than the fixed income allocation from the start.
Watch out
Common mistakes.
- Filing every equity-linked security under fixed income, when many carry equity risk that belongs in the equity allocation.
- Judging a reverse convertible by its coupon alone, without pricing the risk of receiving shares worth far less than the money invested.
- Forgetting the issuer's credit risk, since a default can wipe out the investment even if the linked share performs perfectly well.
Questions
People also ask.
Is a convertible bond an equity-linked security?
Yes, it is one of the oldest and most widely traded members of the family, because its value depends on the issuer's own share price.
Why do issuers pay lower coupons on these instruments?
Because the embedded equity option has value to the investor, and that value substitutes for cash interest.
Do these securities pay dividends on the underlying share?
No, the holder receives the contractual coupon, not the dividends paid to actual shareholders, which is a real cost over a long holding period.
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