What are convertible bonds

Convertible bonds combine the features of debt and equity, making them a hybrid investment instrument. They pay fixed interest like traditional corporate bonds while allowing investors to convert the bond into company shares under predefined terms.

Key points:

• Pay fixed interest until conversion or maturity.
• Can be converted into a predetermined number of equity shares.
• Generally, they offer lower interest rates than regular corporate bonds.
• Provide an opportunity to benefit from rising share prices.
• Help companies raise capital while delaying equity dilution.

A convertible bond is a fixed-income security issued by a company that pays periodic interest and gives you the option to convert the bond into a specified number of equity shares. The conversion terms, including the conversion price and conversion ratio, are decided when the bond is issued.

Unlike ordinary corporate bonds, convertible bonds offer two potential sources of return. You receive regular interest payments while holding the bond, and you may also benefit if the company's share price rises enough to make conversion attractive.

Companies often issue convertible bonds because they can usually borrow at a lower interest rate than they would with traditional corporate bonds. Investors may accept the lower coupon because they receive the added benefit of an equity conversion option.

The table below highlights the key features of convertible bonds.

Convertible bonds are issued in different forms depending on the conversion terms. Understanding these types can help you assess how the investment may perform under different market conditions.

1. Regular convertible bonds

Regular convertible bonds give investors the choice to convert the bond into equity shares or receive the bond's face value at maturity. The issuer pays fixed interest throughout the investment period.

If the company's share price increases significantly, investors may choose to convert their bonds into shares. Otherwise, they can continue holding the bond until maturity and receive the principal amount.

2. Mandatory convertible bonds

Mandatory convertible bonds require investors to convert their bonds into equity shares on the maturity date. Unlike regular convertible bonds, investors do not have the option to receive cash instead of shares.

Because investors must convert the bond, these securities often offer relatively higher interest payments than standard convertible bonds.

3. Reverse convertible bonds

Reverse convertible bonds operate differently from regular convertible bonds. In these securities, the issuer generally retains the right to convert the bond into equity shares at maturity based on the terms of the issue and prevailing market conditions.

The final outcome depends on the company's share price and the conditions specified when the bond is issued.

Convertible bonds offer features of both bonds and shares, making them suitable for investors seeking a balance between regular income and potential capital appreciation.

Income from fixed interest payments

Convertible bonds provide regular interest payments throughout the bond's tenure. Although the coupon rate is generally lower than that of traditional corporate bonds, it can still provide a predictable income stream.

Opportunity to benefit from share price growth

If the issuing company's share price rises above the conversion price, you may choose to convert the bond into equity shares. This allows you to participate in the company's potential growth while initially investing in a fixed-income instrument.

Lower downside risk than equity

Unlike ordinary shares, convertible bonds continue to function as debt securities until conversion. Even if the company's share price declines, the bond may retain value because of its fixed-income characteristics.

Portfolio diversification

Convertible bonds combine debt and equity exposure in a single investment. This hybrid structure can add diversification to an investment portfolio by reducing reliance on a single asset class.

The table below summarises the main benefits.

While convertible bonds offer flexibility, they also have certain limitations that investors should understand before investing.

Lower yield

Convertible bonds usually pay lower interest than traditional corporate bonds because they include the option to convert into shares.

Conversion premium

The conversion premium represents the additional value investors pay for the conversion feature. A higher premium can reduce the bond's effective yield.

Share dilution

When bondholders convert their bonds into equity shares, the total number of outstanding shares increases. This may reduce the ownership percentage of existing shareholders.

Credit risk

Like other corporate bonds, convertible bonds depend on the financial strength of the issuing company. If the issuer experiences financial difficulties, interest payments or repayment of the principal may be affected.

The conversion ratio determines the number of equity shares you receive when converting a convertible bond. It is specified when the bond is issued and remains one of the most important factors influencing the bond's value.

For example, if one bond has a conversion ratio of 20:1, the holder receives 20 equity shares upon conversion.

The conversion ratio directly affects whether conversion is financially beneficial.

• A higher conversion ratio means you receive more shares for each bond.
• A lower conversion ratio means you receive fewer shares, making conversion less attractive if the share price rises.

Investors often compare the conversion ratio with the current market price of the company's shares before deciding whether to convert or continue holding the bond.

Convertible bonds are hybrid securities that combine the predictable income of corporate bonds with the opportunity to convert into equity shares. They provide regular interest payments while allowing investors to participate in potential share price appreciation under predefined conversion terms.

Before investing, you should evaluate the bond's interest rate, conversion ratio, conversion price, maturity period, credit quality of the issuer, and the potential impact of share dilution. Understanding these factors can help you determine whether a convertible bond aligns with your investment objectives and risk tolerance.