Convertible Bonds as an Asset Class: Characteristics and Benefits

Introduction to Convertible Bonds

Convertible bonds are a unique financial instrument that provide the holder with the option to exchange the bond for the issuing firm's common stock. Companies issue convertible debt as a strategic decision to raise capital, balancing the issuance of new equity, convertible, and fixed-income securities. The ability to transform from one form to another gives convertibles characteristics similar to equity securities, effectively combining debt obligations with equity features.

Characteristics and Benefits of Convertible Bonds

Convertibles are essentially bonds with an embedded call option on the issuer's stock. These debt instruments can be converted into equity shares of the company at a predetermined future date. They embody features of both debt and equity, offering periodic coupon payments similar to other debt instruments. Upon redemption, bondholders have the choice to receive shares of the company instead of cash. Warrants, which allow holders to purchase stock at a fixed price, are sometimes issued alongside bonds, offering potential gains if stock prices rise.

Convertible bonds typically offer lower coupon rates compared to straight bonds due to their embedded options. A predetermined conversion ratio dictates the number of common stock shares a bondholder receives upon conversion. Issuers cannot revoke this option, ensuring bondholder rights. For instance, if a bond is callable by the issuer and convertible by the holder, the issuer may call the bond, prompting the holder to either sell at the call price or convert to common shares.

Strategic Advantages of Issuing Convertible Bonds

The primary advantage of issuing convertible bonds is the indirect issuance of equity at a potentially higher price, which can be particularly useful when a firm anticipates a need for permanent capital rather than short-term funding. However, there is an inherent risk associated with convertible bonds compared to direct common stock issuance. A key attraction of convertible bonds is the lower interest rate compared to straight bonds, which results in cash savings and reduced recorded interest expenses.

For example, if a straight bond costs 10% and a convertible bond costs 4%, $1,000,000 of straight bonds would incur a $100,000 interest cost, while the convertible bond would cost $40,000 in interest. These accounting measures should be weighed against actual monetary costs when choosing between convertible and straight bonds. Convertible bonds provide an opportunity for firms to force conversion when the bond's value exceeds the call price, usually requiring a price cushion to minimize cash payouts. Issuing convertibles enables corporations to secure equity financing over time, delaying common stock and earnings per share dilution.

Due to the stock purchase option, companies can sell bonds at a lower coupon rate than standard bonds. The more valuable the bond feature, the lower the yield required to sell the bond. Since convertible bondholders receive a fixed, limited income, more operating income remains available to common stockholders until the bonds convert to stocks. This allows common stockholders to temporarily benefit from the bondholders' limited income. Some firms opt to issue bonds with detachable warrants instead of convertible bonds.

Key Characteristics of Convertible Bonds

• Conversion Price: The predetermined share price at which a convertible bond can be converted into company shares. This price is typically set above the prevailing market price at issuance, influenced by interest rates and issuer credit quality.
• Conversion Ratio: The number of shares an investor receives upon converting one bond. A 100:1 conversion ratio means 100 shares per convertible bond.
• Conversion Date: Convertibles may have specific conversion dates or windows when they can be exchanged for shares, calculated as equity price times conversion ratio.
• Issuance Premium: The markup of the conversion price over the current market price at issuance, often high to defer the dilutive effects of future conversions.
• Yield: The yield of the convertible bond at issuance.
• Maturity: Similar to regular bonds, convertibles have a maturity date when investors receive the bond's principal value, ending the debt obligation.

Advantages of Convertible Bonds

Convertible bondholders initially receive only fixed, limited income until conversion, leaving more operating income for common stockholders. If the company performs well, it shares operating income only with newly converted shareholders. Voting control remains with common stockholders, as bondholders cannot vote for directors. For management concerned about losing control, convertible bonds are a preferable financing option over issuing common stock.

Bond interest is a deductible expense for the issuing company. For example, with a 30% tax rate, the government effectively covers 30% of debt interest charges. Therefore, when planning to raise capital, convertible bonds offer advantages over preferred stock. They help companies secure equity financing gradually, delaying common stock dilution and earnings per share impact.

Conclusion

In conclusion, convertible bonds offer a strategic financial tool for companies seeking to balance debt and equity financing. They provide flexibility, lower interest costs, and potential equity conversion, making them a valuable asset class in corporate finance. Properly managed, they can enhance a company's capital structure while minimizing dilution and preserving management control.

References:

• Black, F., & Scholes, M. (1973). The Pricing of Options and Corporate Liabilities. Journal of Political Economy, 81(3), 637-654. doi:10.1086/260062
• Hull, J. C. (2018). Options, Futures, and Other Derivatives (10th ed.). Pearson.
• Ross, S. A., Westerfield, R., & Jaffe, J. (2013). Corporate Finance (10th ed.). McGraw-Hill/Irwin.