Convertible bonds refer to the type of bonds that provide the bondholder with the right of converting them into no. of shares of equal value.
It could also be known as convertible debt or convertible notes.
Companies with a lower credit rating and higher growth potential are most likely to issue such bonds. In case when the company’s stocks perform good, convertible bonds have the potential to rise in their prices since they have the right to be converted into shares.
When the price of underlying stock increases, it increases the value of convertible security, i.e. convertible bonds. Convertible bonds usually tend to provide a good income to investors.
Convertible bonds ate more appreciable as compared to corporate bonds but on the other hand, they also provide equal vulnerability to losses.
Companies tend to provide a lower yield on convertible bonds because of their ability to be converted into stock and the potential of benefitting investors through a rise in the price of the stock.
In the cases when the value of stock experiences a downfall, investors are unable to convert their security, i.e. convertible bonds to stock, i.e. shares and therefore are only left with the yield to show as their investment.
This is why convertible bonds always offer a tradeoff between return and risk factors.
Investors can invest in such convertible bonds either directly with the aid of a broker or indirectly through a mutual fund investment.
Now there are two major reasons as to why a company would issue convertible bonds
- In order to lower the debt coupon rate as investors are willing to accept convertible bonds with lower coupon rates as compared to other bonds due to its ability of conversion. This leads to saving on interest expenditure in case of large issues.
- For delaying dilution Companies may issue convertible bonds for raising capital and diluting the share of equity shareholders.
Convertible bonds also come with a conversion ratio which determines how many parts of a bond will be converted into stock. It is often expressed as the conversion price of ratio.
Another aspect involves forced conversion where companies might force investors to convert their shares. This happens in the cases when the bonds are to be redeemed and the price of the stock goes high than the price of the security.
Types Of Convertible Bonds
There are majorly three types of convertible bonds, which include:
Mandatory convertible bonds force the investor to convert their bonds to stock at maturity. Such bonds have two different conversion prices. One includes the price below the par value and one includes a price above the par value.
Vanilla Convertible Bonds
Vanilla convertible bonds are the most common sort of convertible security. Such bonds provide investors the right to convert their bonds into certain number of stock at a predetermined conversion price. Such bonds have a fixed date of maturity at which the investors are expected to pay the nominal price.
Reverse Convertible Bonds
Such convertible bonds come with an option of allowing the investor to buy back the bonds in return for cash or to convert it into shares at a predetermined rate at the maturity date.
Advantages and Disadvantages of Convertible Bonds
- The company is at the benefit of issuing convertible bonds because the coupon rate is fixed and low which reduces interest expenses due to the bondholders.
- The interest on such bonds is a tax-deductible expense for the company and therefore it offers the tax saving on interest which is not possible with sources like equity financing.
- Convertible bonds are beneficial to the issuer because they allow fundraising with delaying the common stock and the earnings per share are diluted.
- If a company is not willing to dilute its stock shares in the short or medium term but is comfortable doing so in the long term, convertible bond financing is more appropriate than equity financing. The current company’s shareholders retain their voting power and they may benefit from the capital appreciation of its stock price in the future.
- As the company holds some right on the conversion of the bond and can force an investor to convert its bonds, it serves as a disadvantage for the investor.
- Convertible bonds often have complex characteristics and therefore a lot of market analysis and price research have to be done beforehand.
- Convertible bonds are riskier as compared to other debt tools. In case of bankruptcy, secured debt holders will be prioritized.
- Convertible bonds have some power in diluting the earning per share of a company’s common stock.
Convertible bonds come with a lot of details and intricate work which can make them seem way too complicated for one’s investment.
Basically, convertible bonds act as a security for those investors who are willing to get involved in the growth of a particular company. Convertible bonds usually determine a tradeoff between risk factors and return potential.
Their abilities can bid fair to be ambiguous at times but mostly, convertible bonds cost the limit of an investor’s upside potential for the limit of their downside risk.
No steady income is promised as per the predetermined factors, but convertibles prove to be good in a market where the stock rates tend to rise constantly.