Convertible Bond

Convertible Bond
Source: Tavaga

What is a convertible bond?

A convertible bond is a bond which gives the bondholder the right to exchange the bond for a specified number of common shares of the bond issuing company. It is a hybrid security with debt- and equity-like features. 

Usually, The conversion rate or the price at which the bond can be converted into stock is fixed when the bond is issued.

Is it good to invest in convertible bonds?

For an investor, a convertible bond enjoys quite a few advantages over non-convertible ones. The bondholder may convert into equity share if stock prices go up, automatically participating in the equity upside. 

In the absence of price appreciation, they may continue earning regular interest payments with the promise of principal repayment on maturity.

Of course, the catch is the coupon rate (bond interest rate or yield) on convertible bonds is lower than its non-convertible counterpart, and they are more expensive than non-convertible ones.

But compared to dividend yield on common shares of the issuing company, the coupon rate is higher.

For the issuing company, lower coupon rates mean lower interest expense and debt reduction if the conversion is exercised. Of course, it dilutes existing shareholders’ rights/stock value.

What is the right time to convert bonds into stock?

A thorough analysis of the price of a stock should be made. If the price is increasing consistently, it is the right time for one to convert. Before converting, due attention should be paid to the reason behind the price appreciation of the stock.

Types of convertible bonds

  1. Mandatorily convertible bonds:- on the due date, the bond gets converted into stock
  2. Reversible convertible bonds:- Here the company has a right of whether to convert bonds into stock or not
  3. Vanilla convertible bonds:- Here the investor has the choice whether to convert the bond into stock or keep it till maturity

Advantages of convertible bonds

For the investors

Investors have two advantages of purchasing convertible bonds. Investors profit from an increase in stock value in addition to earning a fixed rate of interest on their investments until they reach maturity.
Additionally, investors in convertible bonds benefit from decreased default risk as at the time of liquidation bondholders are given the first preference in the liquidation process.

For the issuing company

Without having to instantly dilute their shares as is the case with equity financing, the issuing business can raise funds right away.
The issuing company typically offers a lower rate of interest on convertible bonds when compared to the rate on regular corporate debt securities because the investor gets to participate in the share value appreciation process.