A convertible bond is a form of financial product that gives an investor a right or a duty to swap the bond for a set number of shares in the issuing firm at various points during a bond's lifecycle. It is a hybrid investment that includes aspects of both debt and equity.

Like conventional bonds, a convertible bond comes with a maturity period and pays interest to investors. In addition, if an investor chooses not to convert their bonds into equity, they will be paid the face value of the bonds when the bonds mature. But, if an investor decides to convert the bonds into shares of the firm, the bond will immediately lose all of its debt and solely have equity characteristics.

Businesses with a poor credit rating and great development potential typically issue convertible bonds. For finance objectives, the bonds provide greater flexibility than normal bonds. They may be more enticing to investors as convertible bonds give growth potential via future capital growth of the stock price.

Types of Convertible Bonds

In finance, convertible bonds do not fall under any particular category that can be formally defined. Nonetheless, underwriters frequently refer to the following types:

Vanilla Convertible Bonds

They are the most popular type of convertible bonds. At the maturity date, investors can convert their bonds into a certain number of shares at a conversion price and rate that has been decided in advance. Vanilla bonds may be issued with coupon payments throughout the bond term, and they come with a predetermined maturity date. At this point, the investors will receive the bond's nominal value.

Mandatory Convertibles

Investors in mandatory convertible bonds must exchange their bonds for shares at the bonds' maturity. There are typically two conversion values available for the bonds. When investors invest at the minimum price, they will get a maximum number of shares equal to their par value. The second price limits the investor's potential gain above the security's face value.

Reverse Convertibles

The issuer of a reverse convertible bond can either redeem the bond for cash at maturity or convert it into shares of stock at a predetermined conversion price and conversion rate.

Advantages of Convertible Bonds

Convertible bonds are a flexible financing solution with several benefits over traditional debt or equity financing. Some of the advantages include the following:

Reduced Interest Payments

Normally, investors are ready to accept lower interest costs on convertible bonds than on conventional bonds. Hence, issuing corporations may save money on their interest payments.

Tax Advantages

The issuer of convertible bonds may take advantage of interest tax advantages that would otherwise be unavailable compared to equity financing since interest payments on bonds are deductible.

Deferral Of Stock Dilution

Convertible bond financing is preferable to equity financing if a firm is unwilling to reduce the number of its outstanding stock shares in the near or medium term but is comfortable doing so in the long term. The shareholders of the existing firm keep their voting power, and they have a chance to profit in the future from an increase in the value of their shares via capital appreciation.

Cons Of Convertible Bonds

Low Yields

Convertible bonds will give a lower yield than other corporate bonds, but they will also have the option to convert. If the issuer's stock price never exceeds the conversion price, the investor may keep the bond until maturity at a lesser yield.

Portfolio Complexity Has Increased

Individual investors may be unable to add hybrid securities to a basic portfolio. Convertible bonds may not be smart if keeping things simple is important to you.

More Precarious Than Corporate Bonds

Should the issuer declare bankruptcy, convertible bondholders will be paid back after most other kinds of debt, including corporates.

A High Degree Of Coherence With Equities Markets

As a result of the high degree of correlation between stock prices and intermediate price fluctuations in convertible bond security markets, part of the diversification advantage that was touted may be lost. Convertible securities trading at or close to their conversion price will exhibit more volatility.

Example

Suppose an investor were to acquire a convertible bond with a full price of $1,000 and a coupon rate of 2%. A coupon payment of $20 or $10 every other year will be made to the investor as long as they continue to hold the bond. The investor is likely to have acquired the bond not for the interest payments but rather for the possibility of an increase in the equity share price of the issuer, even if they are assured a small stream of income.

Suppose for a moment that the investor had access, at the same time, to the option of converting the bond into equity shares at a conversion price of $15 per share. This suggests a conversion ratio of 66.67 ($1,000/$15). In other words, if the investor converted the bond to equity capital, they'd get 66 shares (plus a fraction) in return.