What are convertible bonds?

Convertible Bond - Meaning, Types, Pros and Cons

Convertible bonds are hybrid securities that combine features of both bonds and stocks. They offer investors the income-generating potential of bonds and the equity participation of stocks. In this article, we will discuss what is a convertible bond, the different types, and the pros and cons of investing in convertible bonds.

What is Convertible Bond?

Convertible bonds in financial markets are hybrid securities that provide investors with the benefit of both a fixed-income security and an option to convert into a predetermined number of equity shares. Investors have the option to convert the bond securities to shares at a specific time during the tenure of the bond, and the value and quantity of the shares are fixed at the time of issue. After conversion, investors become shareholders of the issuing company. Convertible bonds offer a flexible fundraising option and provide investors with both bond safety and stock ownership. They provide similar features to regular corporate bonds with fixed investment periods and interest pay-outs. In terms of interest rates, convertible bonds have lower rates than regular corporate bonds due to the option of converting them into equity shares.

Types of Convertible Bond

There are various types of convertible bonds, which are as follows:

1. Vanilla Convertible Bond: This is the most common type of convertible bond. It has a fixed coupon rate and a fixed conversion ratio.
2. Mandatory Convertible Bond: This type of convertible bond has a predetermined conversion date and a fixed conversion ratio. The bondholder has no option but to convert the bond into shares of the issuer's common stock on the predetermined conversion date.
3. Reverse Convertible Bond: This type of convertible bond allows the issuer to convert the bond into shares of common stock.
4. Contingent Convertible Bond: This type of convertible bond can automatically convert into equity shares if the issuer's stock price exceeds a certain level.

Pros and Cons of Convertible Bond

Pros:

1. Income from fixed interest payments: Convertible bonds offer a fixed interest payment that is usually higher than the dividends paid by common stocks. This makes them particularly attractive to investors who are looking for regular income payments.
2. Participation in stock price appreciation: Convertible bonds give investors the option to convert their bonds into shares of common stock. This means that if the stock price goes up, the value of the bond also goes up.
3. Reduced downside risk: As convertible bonds are hybrid securities; they offer reduced downside risk compared to common stocks. If the stock price falls, the bond still has value because it is also a fixed-income security.

Cons:

1. Lower yield: Convertible bonds typically offer a lower yield than straight bonds of similar quality because of the option to convert.
2. Conversion premium: The conversion premium on convertible bonds is an additional premium that investors pay for the option to convert their bonds into common shares of the issuer. This premium effectively lowers the yield on the bond.
3. Dilution: When the convertible bonds are converted into common shares, it increases the number of outstanding shares, which could dilute the value of the existing shares.

Conversion Ratio of Convertible Bonds

A convertible bond is a type of bond that includes an option for the bondholder to convert the bond into shares of the issuing company's common stock. The conversion ratio of convertible bonds determines the amount and number of shares of stock that bondholders will receive upon conversion. The conversion ratio is typically expressed as a fixed number of shares per bond or as a ratio between shares and bonds.

The conversion ratio is a crucial factor in determining the value and attractiveness of convertible bonds. A low conversion ratio means that bondholders will receive fewer shares per bond when they convert, making the conversion less attractive. Conversely, a high conversion ratio means that bondholders may receive more shares per bond upon conversion, making conversion more attractive.

Conclusion

Convertible bonds offer investors the potential for income and equity gains within a single investment. There are different types of convertible bonds available, and investors should consider the pros and cons of each before deciding to invest. While convertible bonds offer reduced downside risk, they also come with lower yields and the risk of dilution if the bonds are converted into common shares. Overall, convertible bonds can be a useful investment tool for those seeking income and equity participation.