Bonds are debt instruments that investors get in exchange for lending money to a company or even the government. Bonds are valid for a predetermined period and also come with regular interest payments.
These interest payments are fixed based on a predetermined interest rate. On maturity, the company or government issuing the bond returns the money to the investor.
The main reason companies or government issue bonds is to finance their operations, especially upcoming projects or acquisitions. Governments also use them to supplement revenues received from taxes.
For investors, it is a good investment as they can receive regular income through bonds. Similarly, bonds allow investors to diversify their portfolio and are also more secure than equity investments.
Characteristics of a bond
Bonds have many characteristics. These are usually terms that are associated with bonds. These characteristics are crucial and can define different aspects of the bond. They are listed below.
1) Face value
The face value of a bond, sometimes also known as its par or nominal value, is the amount that the bond will be worth at maturity. The face value of the bond is also the basis used to calculate the interest payments on the bond.
The maturity of a bond is the date on which the bondholder returns the bond to the issuing entity. The bondholder also gets paid a certain amount in exchange. As discussed above, the amount is known as the face value of the bond. Bonds can have different maturity periods. Some may be long-term while some may be short-term.
The coupon of a bond is the interest rate of the bond, usually fixed, that the issuing entity pays to the bondholder. Bonds also have coupon dates which define the dates on which the interest payments are due.
The price of a bond is the current market price of the bond and is different from its face value. Bondholders usually trade bonds in the market before maturity. The price of the bond will only be equal to its face value on maturity.
Some specific types of bonds may come with an option to convert, issued by companies rather than governments. In these types of bonds, investors get the chance to convert their bonds into equity shares of a company on maturity. Convertible bonds will also have a conversion price.
The conversion price of a bond is the price based on which the bondholder will receive equity instruments of a company. It is the price on which the company issues its ordinary shares in exchange for the bonds.
Bondholders can use the conversion price of a bond to calculate the number of equity instruments they can get from converting the bonds, known as conversion ratio.
For example, a company issues bonds with a face value of $10,000 (100 bonds at $100 each) and an option to bondholders allowing them to convert their bonds to common equity shares of the company at a conversion price of $20. Based on this information, the bondholder, on conversion will receive 500 ($10,000 / $20) common shares of the company.
Importance of Conversion Price
The conversion price of a bond is of interest to both the issuing company and the bondholder. For the company, the conversion price is a key metric.
Usually, the company goes through a thorough process to determine the conversion price of a bond, as it will be different for every company. This is mainly because the company will always try to maximize the benefits it receives from the conversion.
The company evaluates various factors such as the current market value of its ordinary stocks, its retained earnings, its cost of capital, etc. before deciding the conversion price of a bond. However, the company must also consider the needs of the investors.
For investors, the higher the conversion price is, the lesser the ordinary shares they will receive in exchange for their investment in bonds. On maturity, if the market price of the ordinary shares of the issuing company is higher than the conversion rate of the bonds, the investor will make a profit.
Similarly, the conversion price of a bond also vital as it can help investors easily calculate the equity shares that they will receive upon conversion.
Bonds are debt instruments that companies or governments issue to generate finds. They have various characteristics that define their different aspects, which include their face value, maturity, coupon, price and conversion. Convertible bonds also come with a conversion price. The conversion price is the price at which investors get the ordinary shares of the company.
The conversion price of a bond is also necessary to calculate the conversion ratio. The conversion price is of importance to both the issuing company and the investor, as both will look to maximize their returns.