A convertible bond is a type of debt security that provides an investor with a right or an obligation to exchange the bond for a predetermined number of shares in the issuing company at certain times of a bond’s lifetime.
It is a hybrid security that possesses features of both debt and equity.
Similar to regular bonds, a convertible bond comes with a maturity date and pays interest to investors. In addition, if an investor decides not to convert their bonds to equity, they will receive the bond’s face value at maturity. However, if an investor converts the bonds to the company’s shares, the bond will lose all its debt features and then possess only equity features.
Companies with a low credit rating and high growth potential often issue convertible bonds. For financing purposes, the bonds offer more flexibility than regular bonds. They may be more attractive to investors since convertible bonds provide growth potential through future capital appreciation of the stock price.
Types of Convertible Bonds
1. Vanilla convertible bonds: These are the most common type of convertible bonds. Investors are granted the right to convert their bonds to a certain number of shares at a predetermined conversion price and rate at the maturity date. Vanilla bonds may pay coupon payments during the life of the bond, and come with a fixed maturity date at which the investors are entitled to the nominal value of the bond
2. Mandatory convertibles: Mandatory convertibles provide investors with an obligation to convert their bonds to shares at maturity. The bonds usually come with two conversion prices. The first price would delimit the price at which an investor will receive the equivalent of its par value in shares. The second price sets a limit to the price that the investor can receive above the par value.
3. Reverse convertibles: Reverse convertible bonds give the issuer an option to either buy back the bond in cash or convert the bond to the equity at a predetermined conversion price and rate at the maturity date.
Advantages of Convertible Bonds
Convertible bonds are a flexible option for financing that offers some advantages over regular debt or equity financing. Some of the benefits include:
1. Lower interest payments: Generally, investors are willing to accept lower interest payments on convertible bonds than on regular bonds. Thus, issuing companies can save money on their interest payments.
2. Tax advantages: Since interest payments are tax-deductible, convertible bonds allow the issuing company to benefit from interest tax savings that are not possible in equity financing.
3. Deferral of stock dilution: If a company is not willing to dilute its stock shares in the short or medium term but is comfortable doing so in the long term, convertible bond financing is more appropriate than equity financing. The current company’s shareholders retain their voting power and they may benefit from the capital appreciation of its stock price in the future.
| Pros | Cons |
| Investors receive fixed-rate interest payments with the option to convert to stock and benefit from stock price appreciation. | Due to the option to convert the bond into common stock, they offer a lower coupon rate. |
| Investors get some default risk security since bondholders are paid before common stockholders. | Issuing companies with little or no earnings—like startups—create an additional risk for convertible bond investors. |
| Companies benefit by raising capital without immediately diluting their shares. | Share dilution happens if the bonds convert to stock shares, which may depress the share’s price and EPS (Earning per share)dynamics. |
| Companies may pay lower interest rates on their debt compared to using traditional bonds. |