convertible-bond

Convertible Bond: Meaning, Types, Advantages & Disadvantages

Convertible Bond: Meaning, Types, Advantages & Disadvantages

The digitalization of the financial market opened up endless opportunities to investors. Now it’s no longer accessible by major market players and institutional investors; it is accessible to regular investors also.
Regular investors have the right to participate in any market instruments by submitting a form on several different platforms.
However, participation does not define as knowledge. The financial market is moody; sometimes, it can be good and sometimes daunting for several investors.
For those who are new to the stock market and looking to invest in securities, convertible bonds are such securities that can deliver decent returns. So let’s get deeper and learn more about them.

A convertible bond can be described as corporate hybrid debt security that features both debt and equity components.
A convertible bond allows the purchaser a right or an obligation to convert the bond of issuing company into shares. The value of a share and quantum of share is generally predetermined by the issuing company.
However, the investor has the right to convert the bond into a stock option but only during the tenure of a bond. In other scenarios, a convertible bond is similar to a regular corporate bond.
The primary reason for being similar is they offer a fixed tenure and pays out periodic interest payments at predetermined intervals.
If the investor decided not to convert the bond into equity shares, they would be eligible to receive the bond’s face value upon maturity.

After getting a clear understanding of convertible bonds, let’s talk about the different types of convertible bonds that companies offer to investors. Here’s look at all one by one.

  • Regular Convertible Bonds
  • Several companies issue these types of convertible bonds, usually to the public. Regular convertible bonds come with a fixed maturity date and at a preset conversion price.
    The issuing company offer periodic interest payments to all its investors till the maturity date in exchange for investing in these types of bonds.
    Upon maturity, the investor can make a decision whether to convert the bonds to equity shares of the issuing company at the predetermined conversion price or redeem the bonds at their face value.
    However, these bonds only give rights to investors and not an obligation to convert into shares.

  • Mandatory Convertible Bonds
  • Mandatory convertible bonds are the opposite of regular convertible bonds. These bonds obligate the investor to convert bonds of the issuing into shares upon maturity.
    Mandatory convertible bonds continue to make regular interest payments till the maturity date upon which bonds are compulsory converted into equity shares.
    Several companies offer a higher interest rate on mandatory convertible bonds because they force investors to convert their bonds into equity shares.

  • Reverse Convertible Bonds
  • In this type of convertible bond, the investor or the bondholder has the obligation or right to convert their bonds. It is not the same as regular and mandatory convertible bonds.
    The issuing company holds all the rights to convert into equity shares at a predetermined price upon maturity with reverse convertible bonds.
    However, the issuing company may select to either convert the bonds into equity shares or retain them as such depending on the circumstances and the share price at the time of maturity.

Convertible bonds come with both advantages and disadvantages for the investor and the issuing company. Let’s look at them in detail:
Advantages For the Investor
Investors get dual benefits whenever they subscribe to convertible bonds. Apart from getting a fixed rate of interest on their investments until maturity, investors also enjoy the benefits of stock value appreciation.
In addition to this, investors of convertible bonds also enjoy lower levels of risk. In the event of liquidation of the issuing company, bondholders tend to get first preference on the liquidation proceeds of the company.
The risk of default is minimized because their investments are guaranteed to a specific extent.
Advantages For The Issuing Company
The issuing company gets the chance to raise capital without immediately diluting any shares, which is the case with respect to equity financing. By issuing convertible bonds, the company can put off share dilution technically to a later point in time. Since the investors get the opportunity to participate in the share value appreciation process, the issuing company generally offers a lower interest rate on convertible bonds than the rate on traditional corporate debt securities.
Disadvantages of Both Investors and Issuing Company
Investors and Issuing companies can face the following disadvantages in convertible bonds:
1. Since several investors enjoy the option of conversion, the interest they earn is lower than regular fixed-income securities.
2. If bondholders take a decision to cash in their option of conversion, it will dilute the ownership stakes of the issuing company. That might not bode well with shareholders, leading to a fall in share prices and EPS.
However, investors have the opportunity to invest in convertible bonds through ETF and mutual funds. Such funds track the market volatility closely. Thus, they have the potential for substantial incomes into portfolios majorly dominated by traditional fixed income instruments.

  • What are the advantages of convertible bonds to investors?
  • Investors get dual benefits whenever they subscribe to convertible bonds. Apart from getting a fixed rate of interest on their investments until maturity, investors also enjoy the benefits of stock value appreciation.

  • What is a Convertible Bond?
  • A convertible bond can be described as corporate hybrid debt security that features both debt and equity components.
    A convertible bond allows the purchaser a right or an obligation to convert the bond of issuing company into shares. The value of a share and quantum of share is generally predetermined by the issuing company.

  • What are mandatory convertible bonds?
  • Mandatory convertible bonds obligate the investor to convert bonds of the issuing into shares upon maturity.
    These bonds continue to make regular interest payments till the maturity date upon which bonds are compulsory converted into equity shares.

Final Thoughts

Convertible bonds are a great way to earn higher returns on investments. However, it’s essential to conduct a thorough analysis of the issuing company before subscribing to their bonds.
Investing in a financially sound company that can meet its debt requirements while falling is a great option. Also, make sure to look at the credit rating of several companies before looking to purchase their bonds.