What are Convertible Bonds?
Created on 18 Dec 2020
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Updated on 10 Sep 2022
People who have been active in the stock market industry must have heard about convertible bonds. However, quite often, people tend to get confused about whether these bonds are just bonds or equity. To answer this question, convertible bonds act as both bonds and equity but not at the same time.
Companies ask investors to convert their bonds into equity when there is a lower cash flow in the company. In that case, such companies do not pay any cash to their investors; instead, they offer them a predetermined number of stocks.
Let's dive into the basics and understand how convertible bonds actually function.
Convertible Bond: Meaning
A convertible bond is a flexible option offered by the company to its investors. It is a type of hybrid bond that generates interest payments but can also be converted into a predetermined number of stock or equity shares.
Convertible bonds allow the bondholder to convert their bonds into a predetermined number of stocks. After converting the bond into stocks, the bondholder becomes a shareholder and gets all the rights and benefits that come with it.
Convertible bonds can be described as hybrid security as it provides the features of both debt and equity. These bonds offer the interest yielding features of a bond along with the opportunity of owning the stock.
These bonds act like regular stocks; however, companies offer lower yields on convertibles than corporate bonds because of its conversion feature. If the stocks do not perform well, then there will be no conversion of bonds, and investors will only get the sub-par value of the bond.
Why do companies issue Convertible Bonds?
There are mainly two reasons why companies issue convertible bonds:
- Companies issue convertible bonds to take advantage of offering lower interest rates. This means that the company can get access to funds at a lower cost than they would have to pay for conventional bonds. Investors, on the other hand, tend to happily accept lower interest on convertible bonds as they will also be getting the advantage of converting their bonds into company stocks or even cash.
- Another reason why companies issue convertible bonds is to delay dilution (Dilution is a reduction in the value of a shareholding due to the issue of additional shares in a company without an increase in assets). Raising capital through convertible bonds rather than equity, allows the companies to delay dilution to their equity holders. In simple words, convertible bonds offer an attractive alternative to get funding via straight debt.
Conversion ratio and price are two essential concepts that allow bondholders to understand how the conversion of bonds into stock actually works.
This ratio tells how many stocks a bondholder can avail against one unit of a bond. Suppose, if the conversion feature of the ratio is 5:1, that means investors can receive 5 common stocks against one unit of a bond.
The conversion ratio influences the price of a bond. Suppose, the par value of a bond is Rs. 1,000, and the conversion ratio is 10. The conversion price will be Rs. 100 (Rs. 1,000/10).
Types of Convertible Bonds
Mainly, there are three types of convertible bonds.
1. Vanilla Convertible Bonds
It is a standard type of convertible bond that allows investors to make their own decision on whether to convert their bond into stocks or hold them as a fixed-income until the maturity period.
Usually, if the price of underlying stocks goes down over time, bondholders prefer to hold them till the maturity period in order to receive the face value of their investment. On the other hand, if the stock price goes up during maturity, the bondholders cash-in their option to convert to capitalize on value growth.
2. Mandatory Convertible Bonds
Bondholders of the mandatory convertible bonds do not enjoy the privilege of converting their bonds into stocks whenever they wish to.
It is a type of bond which must be converted into common stock on or before a specific predetermined date.
These bonds usually come with two conversion prices. The first price would establish limits to the price at which an investor will receive the equivalent of its par value in shares. Whereas, the second price puts a limit on the price that the investor can receive above the par value.
3. Reversible Convertible Bonds (RCB)
RCB is a bond that can be converted into debt, equity, or in cash at the discretion of the issuer at a predetermined date and predetermined conversion price. The issuer has the option to buy back the bonds in cash or equivalent numbers of common stocks.
When is the right time to convert?
It becomes very hectic to decide when to convert in the case of vanilla convertible bonds, and investors often grapple with when to opt for conversion. While there's no right time for that, the primary criterion is that the price of such underlying stock should demonstrate an upward trend.
However, it does not end there. An investor should also consider whether the increase in price trumps the face value of such bonds plus the interest they are eligible to earn. If it does, then the conversion is ideal.
Let us take a look at an example of convertible bonds offered by a company XYZ.
Face value of a convertible bond
It can be seen from the table that the conversion price is Rs. 1,000 (Rs.10,000/10). Every year the investor receives Rs.700 as interest on their investments against one unit. The investor holds the bonds for 2 years, and at the point, XYZ shares are trading at Rs. 1100.
In this situation, if the investor decides to convert his stocks. He will receive 10 stocks worth Rs. 1100. If the investor sells them immediately after converting them, the investor can earn Rs.11,000, which outdoes Rs. 10700 (10,000 + 700).
On the other hand, if stocks are traded at Rs. 900 investors would have suffered a loss of Rs. 1,700.
It is important to figure out the right time to convert as this bond is time-sensitive.
Benefits of Convertible Bonds
Apart from the benefits of receiving the interest rates of bonds and the privilege of owning stocks, convertible bonds offer many other benefits to its investors and the issuer. Some of them are as follows:
- Investors receive a predetermined interest rate throughout their tenure and can convert them when stock prices go up.
- Bondholders can capitalize on price appreciation without assuming much of the risk of a fall in value.
- Companies can issue convertible bonds at lower coupon rates than regular debentures or preference shares.
- Companies do not need to dilute ownership when issuing this instrument.
Convertible bonds can prove to be quite profitable for both the firm issuing it and the investors buying it. For the issuer, by offering the potentially valuable opportunity to a holder to convert to shares later, the initial coupon paid can be lower than on a conventional bond.
As far as investors are concerned, convertible bonds are an ideal choice for those investors who wish to invest and get the benefits from both debt and equity instruments at different times.
Convertible bonds tend to provide a security cushion for investors who wish to be participants in the growth of a particular company that they're unsure of. By investing in convertibles, an investor is putting a limit to their downside risk at the expense of limiting their upside potential.
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