Interest rate fluctuations, shifts in the value of the underlying stock, and the issuer’s creditworthiness all have significant effects on the value of a convertible bond. Let’s discuss the nature of convertible bonds, the advantages they offer, and the different types of convertible bonds available.
Convertible bonds are a type of interest-bearing corporate financial asset that can be exchange for a predetermine number of shares of common stock or equity. In most cases, it is up to the bondholder to decide whether or not to convert the bond into stock at any given time throughout the bond’s existence.
What is a Convertible Bond?
An investor in a convertible bond has the option to, or may be require to, exchange their bond for a predetermine number of shares. A convertible bond functions similarly to a traditional bond in that it has a maturity date and pays interest to its holders.
In addition, bondholders will receive par value if they choose not to convert their bonds into shares of stock. The face value or nominal value of a bond, stock, or coupon is the amount list on the certificate representing that security. It’s a value that doesn’t change with age. However, if the bonds are convert into equity by the investor, the bond will no longer have any debt features and will instead have purely equity characteristics.
Businesses with a poor credit rating but significant growth potential frequently issue convertible bonds. The bonds are more versatile than standard bonds when it comes to cashing in. Investors may be more attracted to them if they have a higher chance of seeing a rise in stock price.
Example of Convertible Bond
Let’s pretend ABC issued a $1,000 convertible bond at 4% interest. Each convertible bond is convertible into 100 shares and has a maturity date of 10 years from the date of issuance.
At maturity, the bond’s purchaser will get back $1,000 + $40 in interest payments for the year. However, all of a sudden, a share of the company’s stock is worth $11. As a result, the bond is worth $1,000 while the value of the stock is $1,100 (100 shares x $11 per share).
The bond can be exchange by the buyer for 100 shares of stock. These stocks as a group have a potential market value of $1,100. The goal of convertible bond arbitrage is to profit from price discrepancies between the bond and the underlying stock.
What is the Function of Convertible Bonds?
Companies can raise capital in a variety of ways, and convertible bonds are one of the more adaptable options. A convertible bond is a hybrid investment that provides the potential for equity ownership along with the security and interest payments of a bond.
Each bond has a unique conversion ratio that indicates how many shares of stock can be obtain in exchange for one bond. One bond would be convert into five shares of common stock at a 5:1 ratio.
Convertible securities, such as corporate bonds or preferred shares. It have a conversion price per share that determines the amount of common stock that can be obtained upon conversion.
The price at which a convertible security can be exchange for its original form is determine by the conversion rate. The conversion price and ratio for convertible bonds are specified in the indenture or the security prospectus (in the case of convertible preferred shares).
Types of Convertible Bonds
There is no established category in the bond markets for bonds that can be convert into other assets. However, underwriters frequently discuss the following categories:
Reverse Convertible Bond
The issuer of a reverse convertible bond has the option. At the bond’s maturity date, to either redeem the bond for cash or convert it into equity at a predetermined price and rate.
At the time of maturity, holders of mandatory convertibles are obligated to convert their bonds into shares. Most bonds can be exchange for two different amounts. A purchaser could spend no more than the initial price and yet receive the same number of shares as the par value. The second price caps the investor’s return above par value.
Vanilla Convertible Bond
These bonds are the most popular form of convertible bonds. Bondholders have the option to exchange their bonds for a specified number of shares at a predetermine price and rate on the bond’s maturity date.
The face value of a vanilla bond is guarantee to be payable to investors on its maturity date. And investors may receive coupon payments over the bond’s existence.
Advantages of Convertible Bond
Convertible bond offer a versatile alternative to traditional debt or equity financing with a number of benefits. Read about meaning of debt instruments to understand in depth. The benefits include, among others:
Save Money on Interest Payments
Interest rates on convertible bonds are often lower than those on standard bonds. Since investors expect the bond’s value to fluctuate more frequently. Companies that borrow money might cut costs by reducing the interest they pay.
Unlike with equity financing, the issuer of convertible bonds can save money on interest taxes because the interest they pay on the bonds is deductible.
Delaying the Inevitable Stock Value Decline
Convertible bonds are preferable to equity financing if a company wants to raise capital without immediately diluting its stockholders’ ownership stake. But is willing to accept such dilution in the long run. Current shareholders retain voting rights and stand to gain if the stock price rises in the future.
A corporation may provide bonds with a cash conversion facility in order to attract more investors. The corporation may be able to negotiate a more favorable interest rate and terms by including a convertibility provision. From the perspective of the investor, a convertibility feature allows them to get a regular flow of interest income and the potential to profit from an increase in the stock price. I hope this has been helpful in elucidating the nature of convertible bond as well as their operation, advantages, and potential applications.