In the world of investing, two of the most important asset classes are equity and debt. Equity offers ownership and gives a chance to earn higher returns, whereas debt offers fixed income and capital protection. One insturment that merges both these asset classes is convertible bonds. In this article, let’s dig deep into convertible bonds and how they work.
What are Convertible Bonds?
A convertible bond is a debt security that has an option to be converted into equity at a later date. As long as it is a bond, it has the features of a debt security. Once it is converted into equity, it ceases to exist as a debt instrument and enjoys the benefits that come with an equity instrument. This is why a convertible bond is a hybrid financial instrument.
When a company issues a convertible bond, all the details of the issue, including the face value, interest rate, maturity, conversion rate, conversion date, and the number of shares upon conversion, are clearly specified. As an investor, you will have the right to decide whether you want to convert the bond into equity on the date of conversion. If you wish to convert, you must do it during the tenure of the bond and not after the tenure ends.
How Convertible Bonds Work?
When you invest in a convertible bond, you will receive the interest until the date of conversion. Upon conversion, you will become a shareholder, and you will receive the shares in your demat account and earn a dividend if the company pays one. If you wish not to convert the bonds, you will continue to receive interest until maturity. At maturity, you will receive the face value of the bond.
When a convertible bond is issued, the company specifies the conversion date, conversion ratio and conversion price at the time of issue. The conversion ratio tells the number of shares that you can receive against a bond, whereas the conversion price is the rate at which the bond is converted into stocks. When you convert your bonds into shares, the conversion ratio and conversion price are very important.
Let’s understand how convertible bonds work with the help of an example.
Example
A company issues convertible bonds with a par value of Rs 1,000 on 01/01/2011 for a tenure of 10 years at 7.5% interest convertible after 5 years on 01/01/2016. At the time of issue, it mentions the conversion ratio to be 5:1, which means one bond will be converted into five shares. The conversion price is the face value of the bond divided by the conversion ratio. So, in this case, the conversion price is Rs 200 (Rs 1,000/5).
If you invest Rs 1 lakh in the company’s bonds, you will get 100 bonds and a yearly interest of Rs 7,500 for ten years. After five years, you have an option to convert the bonds into shares.
If you do not want to convert, the company will pay you an interest of Rs 7,500 per annum for the next five years. However, if you wish to convert your bonds into shares, then you will receive 500 shares of the company as the conversion rate is 5:1. Now, the company will not pay you any interest as your bonds are converted into shares. If the share price increases above Rs 200, you can sell it at a profit and earn high returns.
Types of Convertible Bonds
The following are the types of convertible bonds:
Regular Convertible Bonds
Companies issue these types of convertible bonds with a fixed maturity date and at a predetermined conversion price. You will receive periodic interest payments till the bond matures. And, upon maturity, you have the right but not an obligation to convert these bonds into shares.
Thus, you can either convert the bonds to equity shares (at the predetermined price) or redeem the bonds at face value.
Mandatory Convertible Bonds
These bonds work in the opposite way than regular convertible bonds. These bonds pay interest till the bond matures and are converted to equity shares. The investors are obligated to convert their bonds to equity shares upon maturity. Some companies offer higher interest rates to compensate for the mandatory conversion to equity shares.
Reverse Convertible Bonds
The issuing company can choose to convert the bonds to equity shares (at the predetermined conversion price) or retain them on maturity.
Foreign Currency Convertible Bonds
Foreign currency convertible bonds are a type of convertible bond issued in a different currency than the issuer’s domestic currency. Multinational companies usually issue these bonds to raise foreign currency capital. Since the bonds are issued in foreign currency, the principal and interest payments are also made in that same currency.
You can choose not to convert these bonds if the company’s stock price trades below the conversion price (on maturity). In such instances, the company will pay the face value of the bond. If the share price is higher, you can convert them to equity.
Why Does a Company Issue Convertible Bonds?
Convertible bonds are issued by companies with low credit ratings but have the potential to grow at a rapid pace. Convertible bonds offer several benefits to the issuer, which could be why they are a preferred way to raise capital.
- Low cost of funds: Due to the convertibility option, companies can raise debt from the market at an interest rate, which is lower than traditional bonds or bank loan.
- Easier way to raise equity capital: When a company issues convertible bonds, upon conversion the bonds cease to exist and outstanding equity shares increase. A company that couldn’t raise money through issue of equity shares may find it easier to raise money by issuing convertible bonds.
- One drawback for the company is that if too many bondholders decide to convert their bonds into shares, the company’s shareholding will be diluted, impacting the share price.
Should You Invest in Convertible Bonds?
Whether to invest in convertible bonds will largely depend on your financial goals and risk appetite. But here are some advantages and disadvantages of investing in convertible bonds that will help you decide.
Advantages of Convertible Bonds
The following are the advantages of investing in convertible bonds:
- Fixed Income: The issuing company pays interest till the bond matures. The interest is usually higher than the dividends. Thus, convertible bonds are suitable if you are looking for regular income.
- Option to Convert to Equity: Upon maturity, you can convert the debt to equity. The option to convert allows you to decide depending on the market performance.
- Lower Downside Risk: Convertible bonds are hybrid securities. Unlike shares, they do not have unlimited downside risk. Even if the share price fluctuates during the bond tenure, the bond still holds value and generates fixed income.
- Priority in Liquidation: In case of issue default, if the bond hasn’t been converted yet, you will be paid before common stockholders.
- Diversification: Convertible bonds can be a good diversification to your investment portfolio.
Disadvantages of Convertible Bonds
The following are the disadvantages of investing in convertible bonds:
- Lower Yield: Convertible bonds offer lower yields than corporate bonds. This is due to their hybrid nature and option to convert to equity.
- High Correlation to Equity Markets: Convertible bonds have a high correlation to underlying equity stock . The value of the bond will fluctuate according to changes in the share price.
Conclusion
Convertible bonds are a great way to earn high returns and enjoy the dual benefits of debt and equity. However, before subscribing to any convertible bonds, it is important to do a due diligence of the issuing company. Check for the company’s financial performance and credit rating before making an investment decision.
Frequently Asked Questions (FAQs)
What is the difference between equity and convertible bonds?
Convertible bonds are a type of debt instrument that can be converted into equity in the future. On the other hand, equity involves buying shares of the company. Here, you become the shareholder and receive company profits as dividends.
Is a convertible bond debt or equity?
Convertible bonds are treated as debt instruments. However, these bonds have an option to convert to equity, unlike other bonds.
What is the biggest risk in convertible bonds?
The biggest risk for convertible bonds is forced conversion.
What is forced conversion in convertible bonds?
Forced conversion occurs when the bond issuer exercises their right to call the issue. Under such scenarios, the issuer forces you to convert the bond into equity (predetermined number of shares).
What happens when a convertible bond matures?
On the maturity date, the convertible bond is paid either in cash (redeemed at face value) or through conversion into equity (at the predetermined conversion price).
