Convertible Bonds – A Primer

Convertible Bonds – A Primer

In the world of stocks and real-estate investments, convertible bonds are less talked about. Common investors hardly know about convertible bonds, and very few investors of this class deal in bonds. By contrast, companies are always looking for ways to raise capital, and issuing convertible bonds is one such way.

Corporate bonds are the debts or liabilities of a company. Companies issue convertible bonds to lower the coupon rate on debts.

Convertible bonds
Convertible bonds are, by definition, convertible; These bonds are issued by a company and can later be converted in to common shares by the company. They come with a specific timeframe, for instance, more than 10 years. The conversion can only take place at the discretion of the shareholder, who can decide whether to convert a bond into stock on the basis of an evaluation of the stock price. An investor with a convertible bond can benefit from the best features of both bonds and equity shares.

Most companies issue convertible bonds when interest rates are low, as well as to finance or expand their business. Moreover, when a company raises capital through convertible bonds, it can delay the dilution process. The conversion ratio of convertible bonds differs from that of other bonds. A company can fix the conversion ratio. For instance, if a company sets the conversion ratio to 1:20, it means that in lieu of one bond, an investor will be issued 20 common stocks. At times, convertible bonds are issued at certain percentage of premium. Investors must understand that convertible bonds are mostly issued by companies with low credit ratings and good growth potential.

The downside of holding on to convertible bonds is that they normally carry a low rate of interest. When an investor converts a bond into common stock, the company’s debt is reduced. Often, companies can forcibly convert bonds, also called call provision, thus leaving their stockholders with no choice. This usually happens when the stock price is higher than the redeemed bond amount.

Benefits to investors
Investors stand to gain when companies issue convertible bonds. These bonds offer higher yields than common stock. Most investors convert their bonds into common stocks in the hope of that stock price will increase as well. Investors do not mind accepting the lower coupon rate on convertible bonds. Compared to corporate bonds, convertible bonds have greater upside potential. The downside of converting bonds to common stock is that owing to stock dilution, shareholder equity is reduced. In case a stockholder does not convert their bonds, they will receive returns as stated on the bond document.

Conversion ratio
This is also called as conversion premium, and it is the ratio for determining the number of shares that can be converted against bonds. This ratio can be obtained from the indenture of a company. The higher the ratio, the greater is the number of common stocks that are exchanged.

For investors who want to be part of a company without over committing to it, convertible bonds offer security and assurance. However, shareholders are not eligible to vote until execution of the conversion process.

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