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Convertible bonds are fixed-income-bearing hybrid securities that can be converted into a predetermined quantity of shares or common stock. Such conversion is done at certain times during the bond’s life but is usually done as per the judgement of the bondholder. Through convertible bonds, investors have the option of earning fixed interest payments while also having the option of owning the underlying stock.
Read on as we cover more about convertible bonds, their features, and the benefits of investing in them.
Explore the Features of Convertible Bonds
Besides being convertible into stocks, the said bonds also carry the following features:
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Fixed Interest Payments
The convertible bonds allow the bondholders to have a fixed income stream in the form of regular interest payments. These are also known as ‘coupon payments.’ However, the rate of interest on convertible bonds is lower compared to non-convertible bonds due to the added convenience of the conversion option.
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Ratio of Conversion
The conversion ratio of convertible bonds determines how many shares the bondholders will receive after conversion. It is usually depicted as the number of shares per bond. Now, this ratio is fixed at the time of issue of such bonds. For example, if the ratio is 10:1, it means that a bondholder’s one bond can be converted into 10 shares of the company’s stock.
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Date of Maturity
Like any other traditional bonds, convertible bonds also have a maturity date. It is the date on which the principal amount invested by the bondholder is due to be repaid by the issuer company. Thus, if a bondholder has not converted the bonds into shares, their face value will be received on maturity.
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Conversion Price
The conversion price of a convertible bond is the price at which one can convert it into shares. It is usually set at a premium and is often higher than the bond’s face value.
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Call and Put Options
There are several convertible bonds that feature call-and-put options, offering much-required flexibility to the bondholders and the issuers. Using a call option, an issuer company can either redeem or force convert the bonds, often at a premium price. Similarly, using a put option, a bondholder can sell the bonds back to the issuer company before maturity at a specific price. This provides an apt exit strategy for the bondholders, upholding their liquidity.
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Understanding the Benefits of Convertible Bonds
There are several benefits of investing in convertible bonds, which are as follows:
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Potential Capital Appreciation
As the issuer company’s stock price increases, the value of the convertible bonds also goes up. Thus, investors can profit from both the stock’s growth potential and fixed-interest income.
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Low Default Risk
Usually, convertible bonds are issued by companies that have very strong credit ratings. Thus, the said bonds have a minimal risk of default associated with them. It offers bondholders with a sense of financial security.
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Diversified Portfolio
Through convertible bonds, investors are able to enjoy the perks of fixed-income and equity securities. It helps reduce the overall risk of the portfolio while maximising returns.
Wrapping Up!
With convertible bonds, investors have the dual benefit of fixed bond income and the potential for equity growth. Thus, they are one of the best finance instruments for investors who are seeking financial growth. Further, the ability to convert the bonds into stock is definitely an upside worth exploring.
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FAQs About What are Convertible Bonds?
1. Why do companies issue convertible bonds?
Companies usually issue convertible bonds to delay the dilution and raise capital at a lower interest rate. It also allows the company to manage cash flow better without issuing any additional shares.
2. Is there a dilution risk associated with convertible bonds?
If a company decides to convert the said bonds into shares, it means dilution of ownership of the existing shareholders. It might also lead to a fall in the value of existing shares, resulting in a downside for equity investors.
3. Which factors affect the price of a convertible bond?
The price of the convertible bonds is affected by the issuer company’s credit rating, change in interest rates, and the price of the underlying company stock.
