What Is A Convertible Bond?
A convertible bond is a corporate issued fixed income debt security which can be converted into shares of the company’s stock. The bondholder typically has the right to determine when to convert the issue.
How Do Convertible Bonds Work?
Convertible bonds are referred to as a “hybrid security.” This is because a convertible bondholder receives interest payments on the bond but also has the right to become a shareholder in the company at their discretion. These bonds come with a “conversion ratio.” This ratio represents how many shares of the company the bond may be converted into. For example, a bond with a 3:1 ratio would be able to convert into 3 shares of the company. The share price at which these bonds may be converted at is demonstrated by the formula below.
Conversion Price = Bond’s Par Value / Conversion Ratio
It is important to note that because convertible bonds are a hybrid security, they are highly sensitive to factors such as interest rates and the underlying stock’s price.
Convertible Bond Pros
Convertible bonds may help investors protect their capital, with large upside, if used correctly. This is because, in the event of the underlying company failing to grow, bondholders will still receive their principal upon maturity. However, if the company successfully grows, these bondholders may convert into shares and benefit from appreciation. Another pro is the interest payments. These payments are typically higher than the dividend yield provided by common stock.
Why Do Companies Issue Convertible Bonds?
There are some advantages for companies who elect to issue convertible bonds as a financing method. One advantage is the lower interest obligations these bonds posses as opposed to standard bond issues. Another advantage is the delayed dilution of shares. This protects companies from the negative investor sentiment that comes when shares are diluted.
Limitations To Convertible Bonds
Unfortunately, convertible bonds are not perfect securities for either the issuer or investor. One limitation for the investor is the risk. Convertible bonds have lower yields than standard bonds, yet they are more volatile. One limitation for the issuer is that, despite being delayed, convertible bonds may still eventually dilute shares in the event of bondholder conversion.
