What are Convertible Bonds?

Convertible bonds are unique types of debt instruments that help companies meet their capital requirements and allow investors to enjoy the blend of both, debt and equity types of instruments. It is essentially a hybrid finance instrument that allows investors to experience the benefits of a bond and a stock. 

In simple terms, when you invest in a company via a convertible bond, you are entitled to periodic interest payments and the principal payment at the end of the bond’s tenure. But you also get the option to convert your bond into the company’s shares at a specified due date. 

This hybrid function makes convertible bonds an attractive option for both companies and investors. In this article, we will understand more about convertible bonds, their types, their features, and their advantages and disadvantages with the help of an example. 

Key Highlights

• Convertible bonds are financial instruments that combine the benefits of debt and equity. Companies that need capital but do not wish to immediately dilute their shareholding opt to raise funds via convertible bonds.

• Depending upon features like conversion option, conversion ratio and price, there are different types of convertible bonds such as vanilla convertible bonds, mandatory conversion bonds and reverse convertible bonds. 

• Even though convertible bonds offer lower interest rates, investors benefit from potential upside when the issuing company’s share price increases. However, it also comes with the risk of shareholding dilution.

• Investors must assess the market before choosing to convert their bonds into shares to unlock the benefits of the equity market. 

Understanding Convertible Bond

Convertible bonds have similar characteristics to bonds. When investors help the company meet their financial requirements, the company pays regular interest payments (coupon payments) and the principal amount at the bond’s maturity to the investor. But there is one little exception in this process. 

Convertible bonds offer investors an option to convert their bonds into a specified number of company shares, usually at the investor’s discretion. This can be done before a pre-agreed time and at a predetermined conversion price. 

These hybrid (fixed-income and equity) instruments offer companies an effective way to raise capital without immediately diluting their shareholders’ equity. These are popular with investors in both developed and developing countries, as they provide the safety of bonds and the potential to participate in the company’s growth through shares.

Types of Convertible Bonds

Depending upon the features, convertible bonds are of various types. Some of them are mentioned below.

• Vanilla Convertible Bond

This is the most basic type of convertible bond. In this type, the decision of whether to convert the bond into a predetermined number of shares at a specific conversion price or to hold them as fixed-income security lies with the bondholder. 

• Mandatory Convertible Bond

In this type of convertible bond, investors don’t have a choice to retain the bond till the end of the maturity. Bondholders have to convert their bonds into shares before the predetermined date or they will automatically be converted into shares. Until that date, the investors will continue receiving interest payments.

• Reverse Convertible Bond

Unlike vanilla convertible bonds, in the case of reverse convertible bonds, the choice of conversion remains with the issuer. The issuer may choose to convert the bond into a predetermined number of shares or repay the investor via cash on the maturity date.

Features of Convertible Bonds

Several features of convertible bonds make them an attractive investment option. Some of them are listed below.

• Conversion Option

The most basic feature of convertible bonds is their ability to be converted into shares of the company that issued the bonds.

• Interest Payments

Just like regular bonds, the investors of convertible bonds also receive regular interest payments (coupon payments) at a coupon rate fixed at issuance. These rates are generally lower than that offered by traditional bonds since convertible bonds have the ‘convert to shares’ option.

• Conversion Ratio and Price

The ratio at which the bond would split in the number of shares is determined by the conversion ratio. The conversion price is the price at which the investor would be able to convert his bonds into shares. At the time of issuance, this price is usually higher than the current market price. 

• Maturity Date

Convertible bonds come with a maturity date, just like regular bonds. At this date, the issuer must repay the principal amount to the investor. 

• Call and Put Options

Some convertible bonds come with a call-and-put option. This option allows the issuer to convert or redeem the bond before the maturity date. In the case of the put option, investors have the option to exit their investment by selling the bond at a specified price before maturity. 

Advantages of Convertible Bonds

Like all investments, there are various upsides to investing in convertible bonds. Some of the advantages of listed below.

• Upside Potential

If the company performs well, the share price increases. During favourable times, investors have an opportunity to convert their bonds into shares and participate in the capital gains rally. This increases their earning potential as they receive both, the periodic interest payments and the share appreciation price.

• Downside Protection

If the company fails to perform well for some reason and it leads to a decline in the share price, bondholders continue to receive periodic interest payments. On top of that, the investor’s principal value remains guarded. 

• Lower Interest Rates

As the investors get to benefit from both the upside and the downside, the interest rates in convertible bonds are lower than those in regular bonds. This way, the company saves capital on interest payments which is then reutilised for other things. 

• Limited Dilutions of Shares

Convertible bonds provide companies a way to raise funds without diluting their shareholding immediately. This helps companies manage cash flow effectively. 

Disadvantages of Convertible Bonds

While providing several benefits, convertible bonds have a few disadvantages as well. We have listed a few of them below.

• Low Interest Rates

Since convertible bonds have the option to be converted into bonds, the amount of interest payment that an investor would receive in comparison to regular bond interest payment is less. 

• Market Price Risk

There is a predetermined price at which investors can convert their bonds into shares. Thus there is a risk of the current share price not reaching the determined price. During those times, the investors would have to continue receiving lower interest payments. 

• Risk of Dilution

If the number of bondholders who decide to convert their bonds into shares increases, the shareholders may experience dilution. This means that the ownership percentage of the company decreases. 

• Call Option Risk

If there is a call provision, the company can issue a conversion of bonds. Due to this, the investors may lose out of the share appreciation gains. 

Example of a Convertible Bond

Let us assume that XYZ company issues convertible bonds worth Rs. 10 crore with a maturity of 5 years. The interest rate of the bond is 5%, the face value (principal amount) is Rs. 1000, and the conversion rate at which bondholders can convert their bond is Rs. 200. 

This means if the bondholder decides to convert their bonds into shares, they will get 5 shares (Face value – 1000 divided by the conversion amount – 200). Now, when the share price of XYZ Limited rises above Rs. 200, the bondholder may find it profitable to convert the bonds into shares. 

If for some reason the share price remains below Rs. 200, the bondholders will continue to receive periodic interest payments and the principal amount on maturity. 

When is the Right Time to Convert?

Before converting the bonds into shares, investors must consider various factors to determine the opportune moment. Assessing the market stability and emotion is important as the most important aspect is the stock price. Converting will only be attractive when the share price is above the conversion price. 

However, the maturity date must also be taken into account. If the bond is close to its maturity, and the share price is only slightly higher than the conversion price, it would be better to hold and collect the remaining interest payments rather than to convert. 

Conversion Ratio of Convertible Bond

The conversion ratio of a convertible bond is important to determine the number of shares that a bondholder will receive after converting the bond. It is calculated by dividing the par value of the bond by the conversion price.

For eg. If a convertible bond has a face value of Rs. 1000 and the conversion price is Rs. 100. This means that the bondholder will receive 10 shares for every bond they hold upon bond conversion. 

Conclusion

Convertible bonds are hybrid income instruments that offer both the safety of debt and the upside of equity. In these types of bonds, a bondholder has the choice to convert his bonds into shares of the issuing company at a predetermined price. Before the conversion, the bondholder receives periodic interest payments. 

Depending upon features like conversion option, ratio, and price, there are various types of convertible bonds. Even though convertible bonds offer upside potential and downside protection, they provide lower interest rates as compared to regular bonds and have various other disadvantages. 

But after taking all the advantages, disadvantages and stock market conditions into account, investors can determine the right time to convert their bond to receive the benefits of equity.

FAQs on Convertible Bonds