What is a Convertible Bond?
Convertible bonds are fixed-income debt security instruments that convert to securities issued by businesses to raise capital under financial duress. These bonds exhibit hybrid security characteristics, offering regular interest payments and allowing investors to convert the bond into company equity shares & sizeable conversion premiums.
Companies with sub-par credit ratings but good growth potential issue convertible bonds to gain necessary capital funding while offering lower yields to investors. Compared to regular corporate bonds, the interest payments of these bonds are much lower than traditional fixed income instruments. Still, the option to convert when the underlying stock price rises make them attractive to investors.
The coupon payments of convertible bonds are comparatively lower than common stocks. The conversion option is a sweetener for investors, which is why the better the price of the issuing company’s stock, the lower the bond yield.
Quite a few different types of convertible bonds are available on the stock market.
Types of Convertible Bonds
1. Vanilla Convertible
Vanilla convertible bonds are regular convertibles that come with a set conversion price. The conversion price is the stock price that the convertible bond must acquire to offer a decent return when converted. These bonds have a fixed maturity date and offer a slightly lower interest rate than standard corporate bonds.
At the maturity date, investors can turn vanilla convertible securities into equity shares at the current stock price and gain a better conversion premium. In addition, they can redeem the bonds at their par value if they forfeit conversion.
The generic rule for vanilla convertibles is exercising the bond conversion option when the associated share price exhibits a rising trend.
2. Embedded Options
Most convertible instruments have certain features embedded in them. In most cases, they have a call-and-put option integrated wherein the issuer can force bonds to mature at a fixed, predetermined price. The put option facilitates investors to sell a bond at mutually agreed prices.
3. Mandatory Convertible
Mandatory convertible bonds have a particular conversion date and must be converted to stocks once that date is reached. Mandatory convertibles usually come with short tenures and often carry higher interest rates as business force investors to convert.
4. Exchangeable Bonds
Exchangeable bonds are just like generic convertibles, albeit with one unique feature: the underlying stock belongs to a different issuing company.
5. Contingent Convertibles
A relatively secure type of convertible bond, these types of convertible bonds need to reach specific prices above their conversion price before they can be transformed into stocks. Therefore, the stock value appreciation must be above the conversion price. In addition, it must trade in the stock market at that appreciated value for a certain period before it can be converted.
6. Foreign Currency Convertible Bond
The returns from foreign currency convertible bonds come in a currency other than what the issuing company uses. A prominent benefit of FCCBs is that the interest rate of these bonds does not depend upon the currency exchange rates.
7. Reverse Convertibles
Somewhat different from their counterparts, reverse convertible bonds can be converted into either cash or security during maturity. The issuer holds the conversion rights and can either pay the investor in cash or hand over a set amount of shares per the conversion ratio.
Features of Convertible Bonds
A convertible bond exhibits all the features of regular corporate bonds but offers the dual benefits of a fixed income debt and an equity instrument.
1. Coupon Payment:
Convertible bonds offer a specific coupon rate to their lenders/investors. This is interest paid to the investors over the par or face value of the bond. The coupon rate or rate of interest of a convertible bond is lower due to the conversion option, thereby enabling the issuing company to acquire scarce capital at lower costs.
2. Conversion Ratio
The option to convert attracts most convertible bond investors to lend their money. The conversion ratio is the company’s number of shares in exchange for a single convertible. For example, if you receive 20 equity shares after exercising the convert option, then 20 is the conversion ratio of your bond.
3. Conversion Price
Conversion prices are what you get when you divide the face value of the convertible by its number of shares. So, suppose the par or face value of the bond is Rs. 1000, and its conversion ratio is 20. In that case, the conversion price is Rs. 50. For a vanilla convertible bond, the norm is to convert bonds into stocks once the market price of the equity shares increases substantially above the conversion price.
What are the Advantages of Investing in a Convertible Bond?
A convertible bond poses several prominent benefits to investors and issuing companies.
Investors get to enjoy the dual benefits of a hybrid financial instrument. They get a fixed income from the bonds interest payout and have the option to convert & gain equity shares of the issuing company. Investors are assured of the interest expense of fixed income instruments from the issuer till maturity and enjoy any appreciation of the stock value on conversion.
A major decision for bondholders is determining the time of conversion. Major market players and institutional investors suggest conversion during low market volatility, the share price exhibits an upwards trend, and the total return exceeds the bond face value plus the total interest payout till maturity.
Convertible bonds are best suited for investors with low-risk tolerance. If the issuing company dissolves, bondholders get the first preference during the distribution of the proceeds.
For Issuing Companies
A convertible bond is a great way to acquire debt funding when your company is in a cash crunch. Generally issued by companies with less than proper financial health but solid growth potential, the lower interest rate of a convertible debt allows the issuing company to raise capital at low costs. The growth of their stock attracts both major market players and common investors, who look to enjoy the significant returns of growing stock and the security of a corporate bond.
Why Do Companies Issue Convertible Bonds?
Companies issue convertible bonds when they are under financial strain and need some vital boost to their capital reserves. Convertible bonds help companies acquire essential capital funding at low costs. The lower coupon rate of a convertible bond, compared to regular corporate bonds, allows a business to obtain debt funding at lower interest expenses. Moreover, unlike common stock, a convertible bond is tax deductible.
Delay in stock dilution is another primary reason behind issuing convertible bonds. A company comfortable with stock dilution but not in the near future can choose convertible debt financing over equity financing. This is generally the case for businesses with immense growth potential, who are confident of a rise in the value of equity shares in the long term and a higher net income.
Startups are significant issuers of convertible bonds. They issue bonds, especially when contending with projects that may strain their current finances but are sure to rake in the money in the future. In addition, the potential for growth and rise in the value of equity shares attract investors, who can benefit from the appreciating capital in the future.
Conversion Ratio of Convertible Bonds
The conversion ratio of convertible bonds is the number of equity shares associated with a singular bond. You can determine the conversion ratio by dividing the bond’s par or face value by the underlying stock’s conversion price. So, if the share price is Rs. 50, and the linked convertible bond’s face value is Rs. 5000, then the conversion ratio is 100 to 1; that is, 1 bond can be converted into 100 shares of Rs. 50 each.
Convertible bonds are ideal investment vehicles for investors with low-risk tolerance. This is because of the additional security that bonds offer and the fact that bondholders are priority receivers of the proceeds in case of company liquidation.
A bond is termed convertible if it comes with the option to be converted into a set number of equity shares as determined by its conversion ratio. The bondholder can choose to exercise the conversion option at his whims or it may be forced upon him at the discretion of the issuing company; it all depends on the type of convertible bond being invested in.
With the security & fixed interest payout of corporate bonds and the assurance of stock returns, convertible bonds are an excellent investment choice for risk-averse investors.
Investors stand to lose money if the issuing company defaults on interest & principal payments. Also, if there is a drastic fall in the stock prices, investors have to forfeit the promise of stock returns associated with the convertible security.