The Economic Boom. Convertible Bonds – What is it and How Does it Work?

The economic world is shaking. There are more and more corporations, large and small businesses, and there are a large number of tools on the stock market that help investors. The most well — known types are stocks and bonds. Nevertheless, such an investment instrument as convertible bonds is no less popular in the modern world.

1. Convertible bonds. What’s it?

What are convertible bonds ? This is a type of securities — bonds. These securities are issued by corporations and can be converted into shares of the issuing company, if the bondholder so requests. This is one of the varieties of hybrid financial instruments that combines the features of an equity debt security — bonds and shares — a Call option per share of the issuer. When a company issues a convertible bond, it undertakes to pay investors interest at the rate that was previously set in a certain period of time. As soon as the maturity date comes, the bond can be converted either into cash or into a certain number of ordinary shares. The conversion option itself can be available at a pre-set time during the validity period of the security. It is worth adding that the presented security provides the investor with a regular income. However, they have a lower yield than ordinary ones. Convertible bonds give investors a number of opportunities. For example, to participate in the growth of the share price and subsequently make a profit.

2. How to distinguish a convertible bond from other securities?

It should be understood that this type of securities has its own characteristics that distinguish them from others.

Firstly, convertible bonds are a hybrid product, as already mentioned above.

Secondly, this paper has a low coupon yield.

Third, convertible bonds have a potentially higher yield than conventional bonds. If the issuer’s shares begin to grow, the value of the convertible bonds will significantly increase at the moment of approaching the conversion price. If the share price increases above the conversion price, the issuer can expect to receive them at a discount to the exchange price and sell them on the market at the same time.

Fourth, the possibility of forced conversion, according to which the potential yield on a convertible bond may become limited. The reason for this may be different conditions for issuing a security. And in case of a crisis situation, or if the current value of shares is exceeded by a certain range, the price for the conversion of which has already been set, has the right to convert bonds at its discretion.

3. Why do companies issue convertible bonds?

The answer to this question is quite obvious. This type of securities is more “cheap” and “loyal” because of the low coupon income, which the investor is ready to put up with. Also, there are cases when the company’s goal is to issue shares in the future, thereby they resort to such an ornate strategy. One more reason may be the presence of a multi-level project, where convertible bonds can become a starting point for financing. There are also other reasons:

  • You can pay a smaller coupon income to the investor.
  • You can postpone the dilution of your shares with a new issue, since bonds are not converted into shares immediately.
  • Interest expenses on the payment of coupons on debt securities reduce the tax base of the company.
  • Financially weak companies will be forced to issue ordinary bonds with an increased coupon, and for convertible bonds the coupon is usually undervalued.
  • Companies with a bad credit rating have almost no chance of selling ordinary bonds, and convertible bonds will be in demand as a risky but highly profitable investment.

4. What is the reason for the purchase of converted bonds by investors?

This type of securities is very attractive for investors. The reason for this is to get potentially more income with minimal risks. The profit from these securities will be in any case (not counting the issuer’s default), and with the growth of shares, the investor will be able to get a higher profit. And also the reasons are the desire to:

  • Get a reliable coupon income.
  • Get good expensive stocks at a bargain price.
  • Get a high return on investment.

5. Convertible bonds. How do they work?

The principle of operation of this type of bonds is quite simple.  An investor purchases a debt security and receives coupon payments with a certain frequency, which, as a rule, are lower than payments on ordinary bonds of the same issuer. In this case, the investor has the right to exchange the bond for shares of the same company at a pre-agreed price. If the value of shares increases, approaching the conversion price, the value of bonds will also increase. If the value of the shares exceeds the conversion price, the investor will be able to receive them at a discount to the market value and sell them on the stock exchange with a profit for himself.

6. What are the advantages of convertible bonds?

First, convertible bonds provide investors with more stable protection against losses than stocks. This is due to the fact that bond prices do not fall as much as stock prices, if the company loses the favor of investors.

Secondly, in comparison with classical securities, convertible bonds can increase in price if the company’s shares show a high result. The reason for this is the option to convert into shares. In this way, the investor receives speculative income during the sale on the secondary market.

Third, holders of this type of securities are more protected compared to those who hold shares. In a default situation, the shareholders receive the first priority on debt settlement.

Fourth, the possibility of converting bonds into shares allows the investor to benefit from their growth.

7. Will there be an income from converted bonds?

Here it is worth talking about the advantages of this type of securities.

  1. Convertible bonds are a universal financial instrument. The possibility of their exchange for shares allows investors to combine income in the form of coupon payments with earnings on fluctuations in quotations.
  2. This type of securities is distinguished by its reliability. The investor’s capital has increased protection. The owner of such bonds will, under any circumstances, receive payments and the amount of the nominal value when the security is redeemed.

8. Disadvantages of convertible bonds. What are they?

First, the conversion of bonds into shares usually leads to the dilution of shares, which can negatively affect the price and profit dynamics of the stock in the future.

Secondly, issuers with a low rating and a small profit (most often – growing companies) create additional risk for investors who have decided to purchase convertible bonds.

Third, because of the ability to convert a bond into ordinary shares, companies offer a lower coupon rate than classic bonds.

Fourth, most of these types of securities are subject to recall, thereby the issuer can limit the profit of investors. As a result, convertible bonds do not have much potential for growth, like ordinary, classic shares.

Fifth, if the shares show poor dynamics and thus do not reach the set conversion price, the investor will not be able to convert the securities into shares. As a result, his income will be limited and he will receive only a low coupon rate.

9. What are the risks?

Of course, everything cannot be perfect when using these securities. Thus, it is worth moving on to the risks that an investor may face:

  1. In the event that the conversion is massive, there is a great risk of reducing the liquidity of securities, which will subsequently make it difficult to sell assets, and as a result will lead to the risk of losing the expected profit.
  2. In comparison with the yield indicators of ordinary bonds, convertible bonds have a lower yield. If the price of the issuer’s shares remains unchanged or falls, the investor will be forced to abandon the conversion. As a result, you can forget about the expected profit.  This needs to be dealt with in more detail.
  3. Forced conversion as the main risk when using convertible bonds.

As already mentioned, the main feature of convertible bonds is that many of these issues contain an option called Call. As a result of this presence, the issuer has the right to withdraw the bonds. To put it more clearly, the company can launch the process of forced conversion in the case of pre-agreed conditions that are fixed in the securities prospectus.

Based on statistics, forced conversion is carried out if the share price is approximately 130-140% of the conversion price. With this outcome of events, the bond price begins to rise from the moment when the share price approaches the conversion price. In the process of how the stock becomes more expensive, bonds also grow. But, as already mentioned, the presence of a call option protects the issuer. In the event that the share price rises significantly during the circulation of a security (bond), the issuing company will be able to withdraw the bonds, thereby limiting the profit of investors.

Summing up, we can say that convertible bonds are currently well established in the financial market.  This security offers a huge number of advantages for issuers as well as for the investor. Thanks to the convertible bonds, the investor will never lose a fixed amount, but there is a possibility that he will not receive more profit. In any case, convertible bonds are an excellent tool for attracting additional profit.

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