Convertible bonds are a type of corporate debt that shares characteristics with both bonds and stocks. It is a type of bond that provides fixed interest payments to investors. Investors may also convert the bonds into equity in certain cases.
Definition and Examples of Convertible Bonds
A bond is a type of unsecured corporate debt, which means it is not backed by collateral. Convertible bonds allow investors to exchange their bonds for another type of security, typically the company’s common stock. You may hear the terms “convertible bond” and “convertible debenture” used interchangeably.
Like regular bonds, investors receive fixed interest payments known as coupons. If investors do not convert their bonds into shares, they will recover their original investment when the bond reaches its maturity date. However, if an investor converts their bonds into company shares, they will no longer receive interest payments and will instead hold an equity stake.
Some convertible bonds allow you to choose when and how to convert your bonds into company shares. However, some only permit you to convert your securities at predetermined times. The issuer may also require you to convert your bonds into shares in certain circumstances.
The prices of convertible bonds move in tandem with the company’s stock prices. If stock prices rise, the price of the convertible bond will also rise, and vice versa. The bond contract often includes a conversion ratio that specifies the number of shares you will receive upon conversion. For example, a contract may have a conversion ratio of 25:1, meaning that a bond with a par value, say $1,000, can be converted into 25 shares of stock.
In some cases, the bond contract also specifies the conversion price, which is the price the company is willing to trade its shares for the bond. Sometimes, the conversion price changes over time. For example, the contract may state that the conversion price is $40 for the first two years, then $45 for the next two years, and $50 for the two years following that.
How Convertible Bonds Work
Companies often issue convertible bonds when they have not yet established their creditworthiness, but are believed to have high growth potential.
Issuing convertible bonds often allows companies to raise capital faster than they could through traditional debt or equity financing. Companies can save money using this strategy because investors generally accept lower interest payments compared to regular bonds in exchange for the equity option.
Convertible bonds also provide companies with key advantages by issuing more shares. For instance, companies can save on taxes by issuing debt instead of equity because interest payments on debt are tax-deductible.
Additionally, companies seeking to avoid diluting equity stakes in the short term may opt for convertible bonds, which can defer dilution until the bond is converted. When a company issues more shares, it results in equity dilution, reducing the percentage of ownership represented by each share. This can lead to a decrease in the stock’s value.
Advantages and Disadvantages of Convertible Bonds
Advantages
Source of Fixed Income: Convertible bonds provide fixed interest payments known as coupons. However, once the bond is converted to equity, you will no longer receive interest payments.
Opportunity to Buy Shares at a Discount: You can typically convert your bonds into shares at a discount to the market price. However, this can be a disadvantage for existing shareholders because as the share count increases, each share represents a smaller ownership stake.
Less
The risk of stocks: If a company’s stock prices decline, you can continue to hold the security as a bond, rather than converting it to shares, and receive fixed interest payments. Additionally, the claims of bondholders take precedence over the claims of shareholders during the company’s bankruptcy, making it less risky in the event of default.
Disadvantages
Lower interest payments: Due to the presence of the stock option, the fixed payments you receive from convertible bonds are lower than the traditional coupons of bonds.
Default risk: Secured creditors hold the highest rank in the event of the company’s bankruptcy. Bonds are a type of unsecured debt, so if you hold convertible bonds, you will only get your money after the secured debts have been paid off.
Callability: Most corporate bonds are callable, which means the company can call the bonds and force the conversion into company shares.
What This Means for Investors
As an investor, you may find convertible bonds attractive because they provide you with fixed interest payments. You can also benefit from any increase in the company’s stock prices since the conversion terms are predetermined.
If stock prices rise, you may be able to purchase shares at a discount upon conversion, depending on your contract terms. However, if stock prices fall, you may get a higher interest rate by holding the security as a bond. In this case, you might have earned more interest if you had invested in a traditional bond.
Companies are required to disclose financing, including the issuance of convertible bonds, in their 10-Q and 10-K reports, as well as in interim 8-K filings. You can access these forms on the U.S. Securities and Exchange Commission (SEC) EDGAR database. This information can be important for investors because if you own shares in a company that issues convertible bonds, the conversion may dilute the value of your shares.
Key Takeaways
A convertible bond is a type of corporate bond that offers fixed interest payments to investors but also allows the investor to convert the bond into equity, such as common stock, under certain conditions. Investors typically agree to lower interest payments compared to traditional bonds in exchange for the conversion feature.
Companies often issue convertible bonds because they can save money on interest payments and taxes. Issuing convertible bonds also helps them defer equity dilution.
Source: https://www.thebalancemoney.com/what-is-a-convertible-debenture-5195534
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