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Convertible Bonds: What are they & Why are they Important?

By Jemima Faith

A convertible bond is usually seen as the greatest player in the bond sector is here. Highly favorable to its investors, lead in trust and much loved by companies. But what is so special about convertible bonds? But how do companies ensure that they have reserve funding for the smooth running of its activities? This answer can be found in the type of bonds known as convertible bonds.

I know the questions you may be asking right now (such as what is convertible bonds? How convertible bonds works? What are the best convertible bonds, what are convertible bond pricing...) Right?! Let’s try to provide accurate answers to these questions and more…

What is Convertible Bonds?

A convertible bond is a type of bond that allows the bondholders the ability to convert into a either the money value (cash of equal value) or into specified number of shares of common stock in the issuing organization. It is a hybrid type of security with debt and equity (share)-like features. They are most often issued by businesses having a high growth potential and a low credit rating. Convertible bonds are also considered a type of debt security since the companies involves in its practice agree to give fixed or floating interest rate as they equally perform on common bonds for the fund investors. Essentially, these are corporate bonds that have the ability to be converted by the bondholder into the common stock of the issuing company. At a certain point in time, investors may start to demand higher income than common stocks offer and a higher potential for appreciation than the bonds actually provide. In such case, convertible are ideal. 

Convertible bonds, for example, usually issue a lower coupon than standard bonds. However, the possibilities of the bond to be converted to stock might boost the value for the bond to its holders.

Convertible bonds, like other bonds, are considered debt by the issuing company. The company issuing convertible bonds agrees to pay the investors (bondholders) a set rate of interest in exchange for the use of investor funds. Unlike other bond types, this type of bond also provides investors the opportunity to become shareholders by converting bonds to shares of stocks.  

In this article, we’ll cover the basics of these chameleon-like securities as well as their types, advantages and disadvantages.

Types of Convertible Bonds

Underwriters have been doing quite a good job and thus, provided a good number of variations of the initial convertible structure. Although there is not clear cut classification in the financial market: it may be easy to group convertible bonds into the following sub-types:-

Vanilla Convertible Bonds

Vanilla convertible bonds are the plainest convertible structures. They grant the bondholder the right to convert into certain value or number of stocks or shares determined according to a conversion price determined in advanced. They may also allow for coupon regular payments during the life span of the security and have a stated maturity date after which the nominal value of the bond is redeemable by the holder. This type is the most common convertible bond and typically offering the asymmetric returns profile and positive convexity often misunderstood and thus wrongly associated to the entire asset class: at maturity (after about 20 years), the holder would decide to either convert into shares or request the redemption at par depending on whether or not the stock price is above the conversion price.

Mandatory Convertible Bonds

 This type is a common variation of the vanilla sub-type, especially in the U.S bonds market. Mandatory convertible gives the issuing company the right to determine, at maturity, how to convert the bonds, which in most cases has saw the companies forcing the bondholders to convert into shares hence, the term "Mandatory".

Reverse Convertible Bonds

This is a less type of convertible bonds, mostly offered synthetically. They work in a way opposite to the vanilla structure. When the equity price falls far below the conversion price the investor or bondholders can start to expose the underlying performance of the stock and may no longer be able to redeem at par its bond. This negative aspect of convertible bonds is usually compensated for by a high regular coupon payment.

Packaged convertible Bonds

Packaged convertibles are simply straight bonds issue with a call option/warrant wrapped together. Typically, the investor (bondholder) would love to trade with both options separately (either cash or shares). While the initial pay-off is similar to those of plain vanilla, the Packaged Convertibles bonds may have different levels of risks and dynamics that come with them because at maturity the investor would receive some cash and potentially some shares but some cash or share.

Contingent Convertible (CoCos') Bonds

Enhanced Capital Note (ECN) also known as Contingent convertibles (CoCos) are a fixed income instrument that can be converted into stocks if a pre-specified event occurs.  There is a strike price (the price at which a specific derivative contract can be exercised) or convertible bond pricing, which is the cost of the stock when the bond converts into stock. What differs is that there exist another threshold in different the strike price (convertible bond pricing), which determine the point of conversion when certain pre determine or pre specific capital conditions are reached. Issuing contingent bonds is more beneficial to businesses than offering regular convertibles. The concept of CoCo has been particularly discussed in situations relating to the management of crisis in the banking sector. In the insurance sector also, CoCo has been utilized as an alternative way for keeping solvency.

Contingent convertibles bonds offer its users a different business atmosphere. In which case, instead of converting the issued bonds to shares based entirely on stock price appreciation, users or investors in this bond types may choose to take stock (equity) in exchange for debt, in the event that the bank's capital ratio falls below a certain point.

Advantages of Convertible Bonds

 As per tax, the market for convertibles is primarily pitched towards the non-taxpaying investor. The price will substantially reflect (1) the value of the underlying shares, (2) the discounted gross income advantage of the convertible over the underlying shares, plus (3) some figure for the embedded optionality of the bond. The tax advantage is greatest with mandatory convertibles. Effectively a high tax paying shareholder can benefit from the company securitising gross future income on the convertible, income which it can offset against taxable profits.

Convertible bonds are most preferred by investors since it provides protection against heavy losses, however, investors have to pay off some appreciation in value as a compensation. Most often, convertible bonds are said to be callable, that is to say, the issuing company at some point may force bondholders to convert.

Locking into low fixed–rate long-term borrowing

This bond allows companies to monitor the trend in interest rates. This is to catch the lowest point in the market cycle to be able to fund with fixed rate debt, or being able to swap fixed rate convertible bond borrowing with variable rate bank borrowings. Even in situations where the fixed market turns, issuing companied may still have the possibility to borrow through a convertible bond since it carry a lower coupon than it will be in the situation with straight debt funding.

Increase in net worth of the bond

Another advantage of investing in convertible bond is that there is a huge chance of investors making windfall (great) gains because if the company is making good profits and at the time of conversion price of equity share is good than investors can make the good amount of gains from his or her holdings. So for instance, if an investor has 500 bonds at $50 and upon conversion, he gets 250 equity stocks and the price of each stock are offer at $150 then the investor will get $75000 for which $25000 represent the gain that come in due to stock price rising.

 Lower fixed-rate borrowing costs

Convertible bonds provide its issuers the possibility to issue bonds at a lower cost. These bonds are also associated with lower yields (yields are generally 1% to 3% lower than straight bonds).

Voting reduction deferred

The reduction in the voting rights of current shareholders may also be observed following the actual conversion or redemption of the bond. Thus, convertible preference shares general bear voting rights only when preference dividends are in arrears. As a matter of fact, the greatest voting impact is seen when the issuing company decides to issue an exchangeable bond rather than a convertible bond.

Increasing the level of debt gearing

Companies can also use convertible bonds as a channel to increase the total amount of debt it has issue. The current market tends often times restrict the length a company may pull to as way to increase its straight debt, without it adversely impacting upon the cost of debt and the credit rating. This bond type is also regarded by investors as an acceptable risk when the conversion rights are done by mean of compensation.

Higher conversion rate than a rights issue strike rate

The convertible bond conversion ratio issue by the company on a convertible bond is usually higher when compared to the level that the share price ever reached. If we compare the stock reduction on a convertible bond issued for example, a 15 or 25pct premium to a higher stock reduction on a rights issue, should the new shares be offered on, a 10 to 20pct discount to the current share price.

Right to convert bonds to shares

Most beneficial and also one of the major feature about converting bonds is the ability for bonds holders to convert their bonds into stocks or company shares. This do not just give you more value to you investment (in situation where the company is making huge profits), it also make you part of the company, although you may not have some rights such as the voting right.

Bond interest is a deductible expense for the issuing company
For instance, if the business is in the 20% tax bracket, in effect the U.S. government needs to pay 20% of the interest charges in debt. So when the business is planning to raise new capital, convertible bonds will be more beneficial as compared to preferred stock.

Convertible bondholders receive only a fixed, limited income until conversion

This is of utmost benefit to the said company because a bigger chunk of the operating income is available to the common stockholders. If a company does well, it has to share its operating income only with the newly converted shareholders.

 Voting rights are reserves for common stockholders
converting bond holders are not allow the right to vote for directors. This way, any company whose management desk is concern about the company losing of voting control of the business and it looking for the best way of gaining some financing, issuing convertible bonds will be more beneficial than using common stock to raise the needed finance.

They help a company to secure equity financing in a slow manner
Because it takes time for the bondholders to trade their bonds for stock, this delays the common stock and the earnings per share reduction.

Companies selling bonds at a lower coupon rate (converting bond conversion rate)
When there is the need to buy stocks, companies are able to sell convertible bonds at a lower coupon rate compare to standard bonds.

Converting bond conversion ratio

Another benefit of a convertible bond is that since the convertible option is attached to these bonds company has to pay a lower rate of interest on this type of bond as compared to regular bonds which carry a higher rate of interest. However, these low rates it trade off or cover with security you gain in the company.

Disadvantages of Convertible Bonds

The Issuing company reserves the right to force bond conversion
The issuing company has the right to call for forced conversion usually when the price of the stock is higher than the amount it would be if the bond were redeemed. Another instance is during a bond’s call date. This means there is a cap on the capital appreciation of the bond.

As complex securities
Most beginners are most often confused as to whether convertible bonds are stocks or bonds because of their characteristics. You may also want to take into consideration the various factors that can affect the price of these bonds. These can include the market for the underlying stock and the climate of the interest rate.

They involve high risk
If company that issue the bonds files for bankruptcy, convertible bonds holders have a lower priority claim on the corporation’s assets. The secured debt holders have to be paid off first.

They may be traded at a premium different from the current trading price
Investors have to allow the stock to reach the conversion price in order to make the conversion effective.

They at times pose some dangers to the issuing company
Investing in convertible bonds market can reduce the EPS (earnings per share) of the company’s common stocks, not to mention the company also risks losing control.

 Often convert to company’s share not cash

The greatest disadvantage of a convertible bond is seen when the bonds are converted into equity shares. This leads to the reduction of the stake of the owners of the company which does not go well with owners as well as equity shareholders of the company.

Lower interest rate (lower convertible bond conversion ratio)

Another limitation of convertible bond is that those who invest in these bonds get lower interest rate as compared to regular bonds and though lower interest rate is good for the company but as far as conservative investors are concerned they will not be happy with lower return and will stay away from this type of bonds issued by the company.

Lower value at conversion time

Another downside of a convertible bond is that if the prices of the shares of the company at the time of conversion are trading at a lower valuation then it can lead to the loss for the bondholder. For instance, if an investor has 1000 bonds at $100 and at conversion, he gets 500 equity stocks and the price of each stock is trading at $150 then the total value of the bond is $75000 ($150*500) instead of the $100000 investment. Hence in a way bondholder is exposed to the risk of equity market due to convertible bonds.

How Convertible Bonds Works

A company issues convertible bonds when it needs to raise capital. All convertible bonds have an exchange rate also known as the convertible bond conversion ratio. This price can be expressed in different ways and is almost always considerably higher than the stock price at the time of purchasing the bond.

By offering convertible bonds, companies tries to reduce expenditure (offering a low coupon yield), but entice investors with a value-added component. Most convertible bonds have intermediate-term maturities.

Every security or share has a conversion ratio (convertible bond conversion ratio) that represents the amount of common equity stock the bond holder can receive upon redemption. The convertible bond conversion ratio may be stable or it might change over the bond’s life, but it is always adjusted for stock splits and dividends of stock. A conversion ratio of 25 simply means for every $1,000 value the bond the investor redeems or converts, he gets 25 shares of common stock of the company. Actually, the company is giving out a share at $40 ($1000/25)

To be able to fully understand how convertible bonds works, let us take a look at this example. First, you must compare how the current conversion rate in relation to the initial investment rates. Assuming that the person who invested in the conversion bond above (conversion ratio 25) is now trying to convert his bonds to equity stocks. If the current conversion rate is at five 5%, after five years, the investor should be selling at $800. Considering that the company is now selling stock at $30 then the current conversion ratio is 25, the investor current conversion value will be $750($30*25). At this stage, if you convert, you will make a lose

If however, the company increases its bond prices to &50. Then the investor conversion value would be $1,250 ($50*25). At this price, investors are sure to make profits.

A bondholder might, upon the maturity of the bond choose to change the bond into a number of shares of common stock. This will be profitable to him when the share price rises to a comfortable level. If this never happened, meaning share prices are always lower than expected, the bondholder will not convert the shares, he may instead decide to receive a return (cash payment) based on the bond’s stated interest rate.

Remember here that, as the stock price of the issuing company draws very close to the conversion price, the convertible bond at such point may be traded upon just like a stock than a bond.

Another term you may hear is the conversion premium. This is the percentage the stock would have to go up in value to make a conversion profitable for the investor. In the case where the stock have to increase from $15 to $20, the conversion premium will be (5/15) % or 33.3%.

Most convertible bonds have a call provision, meaning the issuing company can force investors to convert the bond into common stock. This is usually seen when the stock price goes to an uncomfortably high level. Investors who wish to convert will have to do so at that price, even if they’d prefer to wait for an even higher price. The upside is not unlimited.

Note also that, even in the even where the bond value goes far down (to a record low value), the bondholder will always be given the par value at the time of conversion (upon maturity). This allows for some downside coverage.

Conclusion

We are certain that at this junction, you should be able to say what convertible bonds are all about or how convertible bonds works. Thus, convertible bonds type remains an effective means for companies to hold part of their money in non-liquid form and also a faster means to generate some good bucks. There are many advantages (with just a few cons) associated with convertible bonds, which makes it a safe form of investment.

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