What are Convertible Bonds? Definition, Example, and Benefits

A convertible bond is a fixed-income debt security that pays interest, but can be converted into common stock or equity shares.There are several risks.

Convertible bonds are special types of loans that companies can take out to raise money but with the condition that lenders can convert them into shares at a fixed price. A convertible bond is a financial instrument that combines features of both debt and equity. It’s a debt because the company borrows money and promises to pay interest and repay the principal. But it’s also like equity because the bondholder has the option to convert the bond into shares of the company’s stock.

The core idea behind convertible bonds is that they provide a fixed income stream through bonds and can also provide growth like equity. Companies issue convertible bonds to raise money without diluting ownership too quickly. It’s a way to get funds while offering investors the potential for higher returns if the company does well.

What are the Types of Convertible Bonds?

Types of convertible bonds:

1. Vanilla Convertible Bonds

Vanilla convertible bonds are the most common type of convertible bond. They give the bondholder the right to convert the bond into shares at any time before the bond matures, so whenever you feel the situation is beneficial for conversion, you can convert the bonds into shares. Vanilla convertible bonds also allow you to buy shares at a set price.

Vanilla convertible bonds are an attractive way to raise capital because, due to the added conversion feature, they typically offer lower interest rates than regular bonds. 

2. Mandatory Convertible Bonds

You cannot convert all convertible bonds into shares whenever you want. With Mandatory convertible bonds, the investor has to convert the bond into shares at maturity and not before maturity. You don’t have a choice but can convert the bonds into shares at the time of maturity. Because of the mandatory conversion feature, these bonds usually have higher interest rates than vanilla convertibles.

For companies, mandatory convertible bonds provide a way to raise capital while ensuring future equity conversion, which can strengthen the company’s balance sheet by reducing debt and increasing equity.

3. Reverse Convertible Bonds

Reverse convertible bonds are a type of structured investment product where the bondholder receives high coupon payments but might be obligated to accept shares of the underlying stock instead of cash at maturity, depending on the stock’s performance. 

Reverse convertible bonds are linked to the performance of a specific stock or a basket of stocks. If the stock’s price falls below a predetermined level, the bondholder must accept the stock instead of cash repayment of the principal.

What is the Structure and Mechanism of Convertible Bonds?

Conversion Ratio and Conversion Price

Conversion ratio and conversion price are major matrices in convertible bonds because they decide the ratio and the price at which the bonds will be converted into shares. The conversion ratio dictates the number of common shares a bondholder will receive upon conversion. A higher conversion ratio means that the bondholder will get more shares upon conversion, which benefits the investors.

The conversion price is a fixed price set at the time of issuance. Like the convection ratio, it represents the theoretical share price at which the bondholder’s investment would be equivalent in value to the underlying common stock. Whenever the conversion happens, the price will be the conversion price set. 

Embedded Options and Triggers

Convertible bonds often have embedded options that significantly affect their value and the relationship between the issuer and the bondholder. A common embedded option is the call feature, which gives the issuing company the right to redeem the bond before it matures at a specific call price. This call feature can impact investors by forcing them to convert their bonds or accept the call price, potentially limiting their potential gains. 

However, if the stock price rises significantly, the call feature can benefit bondholders. In this scenario, the issuer is more likely to exercise the call option, triggering the conversion and allowing investors to realize gains. Additionally, some convertible bonds include conversion triggers, which are specific conditions that must be met before the bond can be converted. These triggers can depend on factors such as the stock price reaching a certain level or a corporate event occurring.

What are the Benefits of Convertible Bonds?

1. Lower Interest Payments

For corporations, convertible bonds are beneficial because they pay a lower interest rate because of the investor’s conversion option. Investors accept the lower interest rate because when the company grows, they have the option to convert the bonds into shares and earn from the company’s growth.

2. Tax Advantages

The tax treatment of convertible bonds can vary depending on the jurisdiction and specific circumstances. However, in some cases, converting a bond into shares can offer tax advantages. For example, if the bond is held for a sufficient period, the gain realized from the conversion may qualify for long-term capital gains treatment, which is often taxed at a lower rate than ordinary income.

3. Deferred Stock Dilution

Convertible bonds give companies a flexible way to raise money without immediately diluting their stock. Instead of issuing more common stock, they can issue convertible bonds, which helps them avoid increasing the number of outstanding shares right away. This approach helps companies maintain control and ownership structure and keeps their earnings per share intact. 

What are the Risks Associated with Convertible Bonds?

1. Credit Risk

One of the fundamental risks with convertible bonds is that a company may default on its promise of interest payments. If the company experiences financial difficulties or bankruptcy, investors have the risk of losing their principal amount with interest. Before investing you must check the creditworthiness of the issuer of the bonds.

2. Interest Rate Risk

Any kind of bond, traditional or convertible, is susceptible to interest rate risk. As interest rates in the overall economy rise, the value of existing bonds, including convertible bonds, declines. This is because investors can obtain higher yields on newly issued bonds, making older bonds with lower coupon rates less attractive. 

3. Market Volatility Risk

Convertible bonds are influenced by both the bond market and the equity market, making them subject to market volatility risk. The value of the bond is linked to the underlying stock price, as the conversion option becomes more valuable as the stock price rises. However, if the stock price declines significantly, the value of the convertible bond may also decrease. This dual exposure to interest rate fluctuations and stock price movements introduces additional uncertainty for investors.

What is the Process of Issuing Convertible Bonds?

Issuing convertible bonds involves several key steps:

Step 1: First, a company identifies its capital needs and decides to raise funds through convertible bonds. The company then collaborates with investment banks, acting as underwriters, to structure the bond terms. These terms include the face value, coupon rate, maturity date, conversion ratio, and call provisions.

Step 2: The underwriters conduct market research and analysis to determine the appropriate terms and pricing for the bond. Once they finalize the terms, they create an offering document outlining the bond’s details and risks. This document is then filed with regulatory authorities for approval.

Step 3: After gaining regulatory approval, the underwriters market the convertible bonds to investors through roadshows, investor presentations, and electronic communication. Their goal is to generate interest and build an order book for the bond issuance. Once they fill the order book, the underwriters allocate the bonds to investors based on their orders and pricing. The proceeds from the bond sale are then transferred to the issuing company, providing it with the necessary capital.

What is the Impact of Convertible Bonds on Financial Markets?

• Influence on Corporate Financing

Convertible bonds significantly influence corporate financing strategies by offering a hybrid of debt and equity; they provide companies with a flexible and attractive way to raise capital. Compared to traditional bonds, convertible bonds typically carry lower interest rates due to the embedded option to convert into equity. 

This lower cost of capital can be advantageous for companies seeking to fund growth initiatives, research and development, acquisitions, or debt refinancing.

• Market Behavior and Trends

The overall market for convertible bonds has experienced fluctuations over time. Periods of economic growth and low interest rates tend to favor convertible bonds as investors seek opportunities for both income and capital appreciation. Conversely, during periods of economic uncertainty and rising interest rates, the appeal of convertible bonds may diminish.

What is the Comparison with Other Financial Instruments?

Comparison with Traditional Bonds

Convertible bonds are quite different from traditional bonds in terms of their risk and reward. Both types of bonds are essentially loans to a company, with a promise of regular interest payments and the return of the principal amount. Because of the conversion feature, convertible bonds come with lower interest rates compared to traditional bonds with similar credit ratings. 

Additionally, valuing convertible bonds is more complex than valuing traditional bonds. Convertible bonds are not only influenced by interest rates but also by the company’s stock price, which can make their pricing more volatile. In contrast, traditional bonds are mainly affected by changes in interest rates.

Comparison with Equity Securities

Convertible bonds are similar to equity securities in that they can appreciate in value. However, they also have unique features. Unlike common stocks, convertible bonds pay regular interest and have a set maturity date, while common stocks do not.

Convertible bonds offer a safer way to invest in equity compared to buying common stock directly. If the stock price drops, bondholders only risk the bond’s value, whereas common stockholders face the full impact of the price decline. However, the potential gains from convertible bonds are limited by the conversion ratio, which means they can’t appreciate as much as common stocks.

What is the difference between a callable bond and a convertible bond?

The only difference between a callable bond and a convertible bond is that a callable bond allows the issuer, usually a corporation, to redeem the bond before its maturity date, while a convertible bond provides the investors the right. Callable bond benefits the issuer, enabling them to refinance their debt at lower interest rates when market conditions improve. To compensate investors for the risk of early redemption, callable bonds typically offer higher coupon rates.

Why would a company issue convertible bonds?

The main reason a company issues a convertible bond is because Convertible bonds allow companies to raise capital without immediately diluting shareholder ownership. By delaying the conversion into shares, companies can maintain control and preserve earnings per share. Also, issuing convertible bonds can positively impact a company’s credit rating. A stronger credit rating can also improve investor confidence and access to capital markets.

Why would an investor prefer a convertible bond?

There are various reasons an investor could prefer a convertible bond;

1. Income and Growth Potential

With convertible bonds, Investors receive periodic interest payments, which can be a source of steady income, and the option to convert the bond into shares offers the potential for significant capital appreciation if the company’s stock price rises substantially. 

2. Risk Mitigation

The bond part of the investment sets a minimum value, which helps limit potential losses if the market or company performance worsens. Convertible bonds are usually less affected by interest rate changes than traditional bonds because the equity part can balance out some of the negative effects.

3. Portfolio Diversification

Convertible bonds add diversity to a portfolio by giving you exposure to both fixed-income and equity markets. By including them, you can potentially reduce the overall volatility of your investments.

FAQ

Q. How do Convertible Bonds work?

1. Convertible bonds operate as traditional bonds, paying regular interest payments to investors. However, the key distinction lies in the embedded option to convert the bond into shares.

Q. What are the benefits of investing in Convertible Bonds?

1. There are various benefits of the potential for higher returns for investors, lower interest rates for issuers, and portfolio diversification.

Q. What are the risks involved with Convertible Bonds?

1. Credit risk, interest rate risk, market volatility, and dilution risk are the different risks associated with convertible bonds.

Q. How can I invest in Convertible Bonds?

1. Convertible bonds can be purchased through your brokerage accounts. You can also gain exposure to convertible bonds through mutual funds or exchange-traded funds (ETFs) that specialize in this asset class.

Braden Chase

Braden Chase is an investor, trading specialist, and former research specialist for Forex.com who helps aspiring investors develop the confidence and habits they need to make an income from the market. Braden has served as a registered commodity futures representative for domestic and internationally-regulated brokerages and has also spoken & moderated numerous forex and finance industry panels across the globe.

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