What are convertible bonds?
Convertible bonds are a type of corporate bond that can be traded on the open market and are typically issued by firms with high credit ratings.
The investor in convertible securities receives cash interest payments, as well as shares of stock if they choose to convert their investment into common equity at maturity or before the call date.
Convertible bonds offer an investor several benefits over traditional bonds. These bonds usually pay a coupon (a fixed rate of interest) and offer the investor a choice of two payout options: cash payment or stock ownership.
An investor who chooses to convert the bond into common equity will receive the call price if it is above the original investment, if not, then the original investment is forfeited.
There are several reasons why an investor would choose this option including;
- To hedge their stock exposure against a market crash in case they face a margin call or need money to pay for taxes on capital gains.
- Convertible notes are also popular with private equity firms because they allow investors to buy more common equity than they could afford with their resources. This allows private equity firms to sell convertible securities and then purchase common stock after the bond has converted into shares, thereby increasing their ownership in a company without using any of their funds. This strategy is called a “ratchet.” One downside to this approach is that if market conditions change and the value of shares declines, investors may find themselves underwater with little hope of ever recovering their initial capital outlay.
- A third party such as another investor might hold call options on bonds that it originally didn’t own. In this case, the investor would choose to convert the bond into a common stock because he believes that he cannot find another bond of equal value to purchase before maturity.
A convertible note is a type of unsecured debt financing where an investor makes an upfront payment in exchange for a loan that can be converted into equity.
Convertible notes are popular with startups early in their development because they allow entrepreneurs to raise capital without giving up equity in their company.
Startup founders often use convertible notes when raising seed funding or angel capital, because they provide some measure of security to investors while allowing the startup time and flexibility to build their product without giving up a great deal of control over the company.
An investment banker may advise a startup founder on how much money they should ask for to raise adequate capital without diluting their ownership stake too quickly.
Convertible Bonds that May Be Exchanged for Common Stock include,
1. Vanilla convertible bond: This type of bond allows the bondholders the option of becoming shareholders once a predetermined price per share is reached. The conversion price on a vanilla convertible is lower than the current market price, so investors have to pay a premium over the market to convert their debt into common stock. This type of investment has more risk than a typical corporate bond but also has the potential for greater rewards.
2. Putable convertible bond: This type of convertible bond gives investors the option to sell their debt at a predetermined price. Putable convertibles are especially popular among hedge funds because they present an opportunity to simultaneously go long and short on stocks with limited risk.
3 . Knock-in or knock-out (KI/KO)convertible bond: KI/KO bonds include some sort of trigger that allows them to be converted into common stock or cash based on some predefined criteria or event. KI/KO bonds can be very complex and confusing for investors, but they do allow issuers an added level of control over their capital structure.
4. Mandatory convertible bonds: This type of convertible bond is issued when the equity market is bearish, meaning that the price of the common stock is below the conversion price. Companies can put a limit on how much their stock price can rise before bondholders decide to convert their debt into a predetermined number of shares.
5 . Cumulative convertible bonds: This type of convertible bond gives holders an option to convert at any time, which means that investors can call their bonds before maturity if they want or keep them until maturity and collect interest payments along the way.
6 . Accretive convertible bonds: This type of convertible bond increases in value as specific company metrics improve over time. Measuring accretion is sometimes difficult, but accretive convertibles are generally considered safer than traditional convertibles because they have valuable trigger mechanisms to protect investors against adverse changes in the company’s business performance.
7 . Convertible preferred stock: Convertible preferred issues combine some of the features of a convertible bond or preferred stock. Like other convertibles, convertible preferreds give investors the option to trade in their debt for common stock. Like other issues, convertible preferreds typically appreciate increases in the price of the company’s stock and give investors an option to receive a fixed rate of interest on their investment.
8. Rubric bonds: Rubric bonds work just like traditional convertibles except that they include a certain percent increase in value if certain financial ratios are met. This feature gives these securities more leverage than traditional corporate bonds because they have less downside protection and include an incentive factor that rewards investors if specific company metrics improve during the term of the bond. They can also be used in conjunction with risk management hedging policies to ensure that a company’s book value is at least at a specified level.
9 . Cumulative dividend convertibles(CDCs): CDC securities combine some characteristics of both vanilla and putable convertibles by giving holders an option to sell them to someone else for cash or common stock anytime before maturity, but also reward them for holding on and collecting dividends for as long as possible (a feature that makes them distinct from vanilla convertibles). The CDC market hasn’t grown as much as other convertible markets, and research into the instrument has largely been confined to case studies.
10 . Compound-interest convertibles: These issues give investors an initial coupon rate of interest, but then add a floating interest rate in future years that is tied to an external reference rate or index. This can allow investors to benefit from rising global interest rates while also guaranteeing a minimum return on their investment.
Pros and cons of convertible bonds:
Positives Negatives Convertible bonds enjoy tax benefits
Greater leverage than regular bonds (risk)
A convertible bond may appreciate if the company’s stock appreciates and may increase the return on your investment.
Convertible bonds are not as secure as traditional fixed-income instruments. Since convertibles are debt securities, they possess greater risk than traditional fixed income securities, like Treasury bills or corporate bonds.
If you hold a convertible maturing at a time when the underlying stock price is low, you have to convert it into common stock at that time, and you will receive less money buying back a convertible bond than if you sold it back to the original dealer.
If the company’s stock is trading low because of poor fundamentals, then the convertibles may not have much of an upside.
When you sell a convertible bond back to the original dealer, that dealer will likely offer you less than what it cost to buy the convertible bond from them.
The reason for this is that when you purchase a convertible bond from a dealer, that dealer needs to make money off of it.
So if you bought a convertible at $100 and sold it back to a dealer at $75 because the stock price dropped, then the dealer will make less money than if he or she was in control of your investment all along.
This is why you should try to sell a convertible bond back to the dealer at the right time to get the maximum payoff on your investment and much more benefits.
A convertible bond’s value can change rapidly and can decrease in price during the time you own it. The value of a convertible bond may be influenced by many factors, including general market conditions, overall interest rates, and specific news affecting a company or industry.
Investors who hold convertibles for their entire life often sell them before maturity because they need cash for other investments.
This reduces upside potential from capital appreciation as well as from an increase in investor demand for the bonds’ conversion options since these bids presumably would push up prices for all outstanding bonds of that company.
Convertible bonds have regular payments fixed in terms of both interest and principal, which are generally lower than those paid on common stock.
In addition, convertibles differ from standard fixed-income securities in that they have embedded options whose values could vary depending on how their underlying securities perform or where interest rates stand over their term.
Convertibles usually have longer durations than common stocks, and they also typically have higher cash flow volatility. These characteristics result in convertibles’ conveying more risk than do more conventional fixed-income securities.