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Convertible bonds as an asset class: characteristics and benefits

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Convertible is a bond that is exchangeable at the option of the holder for the issuing firm’s common stock. Companies issue convertible debt is the decision to issue new equity, convertible and fixed income securities to raise capital money is managed by some factors. Their changing from one form, state or mind to another feature also give them features of equity securities. It is a combination of two things security with money owed and equity.

Convertibles basically are bonds with a call option on the stock attached. Convertible bonds are debt legal documents that can be converted into equity share of the company at a future date. Their security has feature of debt and equity. It pays occasional coupon interest just like any other dent of object used to measure something. At the time of redemption of bond the bonds can choose to receive share of the company instead of cash. Warrant are the option that allow the holder to buy stock at a fixed price, by that way providing a gain if the price of the stock rises. Some bonds are issued with warrants.

As with convertibles, bonds with warrants have a lower coupon rates than straight bond. A preset changing from one form, state or mind to another ratio exists for the bond such that the bondholder will get a stated number of shares of common stocks for each bond one redeems. A bond issuer cannot take away option. For example, if a bond is both call able by the bond issuer and convertible by the bondholder, the issuer could call in the bond and force the bondholder to either sell the bond at the call price or convert it to a common shares. The first or most important reason for issuing convertible bond is that it is an indirect means of issuing equity at a higher price or higher owed to be converted into common stocks. It is useful where the firm wants an expectation of permanent rather than limited-lived capital. However, it can properly be argued that there is more risk to the firm with the issuance of the convertible bond that with the direct issue of common stock.

A fist or more important attraction of convertible bond is that a (compared to other things) low interest rate can be set compared with a straight bond. This is saving cash paid out as interest as well as a reduction in the recorded (accounting) interest expense of the period. This way if straight bond costs 0.10 and convertible bond costs 0.04, $1,000,000 of straight bond would have a recorded interest cost of $100,000 and the convertible bond would have an interest cost $40,000. These are accounting measures of cost and not the money-based cost that should be the basis of the decision when one is choosing between convertible and straight bond. The opportunity for a firm to force conversion arises value of the bond is larger than the call price. Usually a price cushion must reduce chance of the firm paying out cash. Issuing convertible bond helps a corporation get equity financing in delayed manner, as it takes time for the bondholders to trade their bonds for stock. This process delays the common stock and earnings per share dilution.

Corporations can sell bonds at a lower coupon rate than a standard bond because of the stock purchase option. The more the bond feature is worth, the lower the yield it will need to sell the bond. Because convertible bondholders only receive a (compared to other things) small, fixed income, more operating income is available to the common stockholders until the bond convert to stocks. This allows common stockholders to (only for a short time) bondholders. Instead of issuing convertible bonds, some firm choose to issue bonds with detachable warrants.

A convertible bond can be described by the following characteristics:

  1. Conversion price
  2. The pre-serious and stub born share price at which a convertible bond can be converted into the shares of the company. The conversion price is usually at a high price or high cost to the prevailing market price when the bonds are issued. It depends on the level of prevailing interest rates and the credit quality of the issuer.

  3. Conversion ratio
  4. It is the number of shares that an investor gets after converting one bond. A conversion ratio of 100:1 will mean that the investor will get 100 shares for each convertible bond that he/she holds.

  5. Conversion date
  6. Convertibles can be designed to have certain periodic conversion dates or windows in which these can be converted into the shares of the issuing company, which equity price x conversation ratio.

  7. Issuance premium
  8. It means the markup of the conversion price over the current market price at the time of issuing the convertible bonds. This is usually high to push the dilutive effects of the bonds in the future.

  9. Yield
  10. Yield of the convertible bond at the time of issuance.

  11. Maturity
  12. Like a regular bond, a convertible bond also has a maturity. It is the time when the investors get the principal value of the bond back and the debt expires.

Advantages of convertible bonds

  1. Convertible bondholders can only get fixed, limited income until conversion.
  2. A larger 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.

  3. Voting control is the hands of common stockholders.
  4. Bondholders cannot vote for directors. So if a management level of a company is concerned about losing voting control of the business and need another way of financing, selling convertible bonds will be more advantageous than using common stock for funding.

  5. Bond interest is a deductible expense for the issuing company.
  6. For example, if the company tax rate is 30 percent, the federal government actually needs to pay 30 percent of the debt interest charges. So when a company is plans to raise a new capital, convertible bonds are more advantageous than preferred stock.

  7. They help a company in securing equity financing in a delayed manner.
  8. Because it takes time for the bondholders to trade their bonds for stock, this will delay the dilution of common stock and the earning per share.

  9. The company can sell bonds at a lower coupon rate
  10. Because there is an option to purchase stocks, companies can sell convertible bonds at a lower coupon rate than standard bonds.

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GradesFixer. (2019). Convertible bonds as an asset class: characteristics and benefits. Retrived from https://gradesfixer.com/free-essay-examples/convertible-bonds-as-an-asset-class-characteristics-and-benefits/
GradesFixer. "Convertible bonds as an asset class: characteristics and benefits." GradesFixer, 11 Feb. 2019, https://gradesfixer.com/free-essay-examples/convertible-bonds-as-an-asset-class-characteristics-and-benefits/
GradesFixer, 2019. Convertible bonds as an asset class: characteristics and benefits. [online] Available at: <https://gradesfixer.com/free-essay-examples/convertible-bonds-as-an-asset-class-characteristics-and-benefits/> [Accessed 9 August 2020].
GradesFixer. Convertible bonds as an asset class: characteristics and benefits [Internet]. GradesFixer; 2019 [cited 2019 February 11]. Available from: https://gradesfixer.com/free-essay-examples/convertible-bonds-as-an-asset-class-characteristics-and-benefits/
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