What are Convertible Bonds? Reasons for Issuing Convertible Bonds

Convertible bonds are a unique type of debt instrument that offer the benefits of both bonds and stocks. They are issued by companies as regular bonds but come with an option for the bondholder to convert them into a predetermined number of equity shares after a certain period. This feature makes convertible bonds attractive to investors seeking fixed income with capital appreciation.

What are Convertible Bonds?

A convertible bonds meaning is a type of bond that gives the holder the option to convert it into a predetermined number of the issuing company’s shares, usually at a later date. It combines features of both debt (fixed interest income) and equity (potential to convert into shares) offering investors the safety of bonds with the upside potential of stocks.

How Does Convertible Bond Work?

Convertible bonds function like regular bonds providing investors with fixed interest payments. However, they also include an option to convert the company’s shares at a predetermined conversion ratio. This feature allows investors to benefit from stock price appreciation while receiving bond interest.

For example: If you purchase a Rs 20,000 convertible bond with a 5% annual interest rate, a 10-year maturity and a conversion ratio of 50. You will earn Rs 1,000 annually in interest.

However if the company’s stock price rises to Rs 500 you can convert the bond into 50 shares worth Rs 25,000. If the stock price remains low the bondholder can hold the bond until maturity and receive the entire principal amount.

The conversion ratio determines how many shares an investor receives upon conversion. Once converted the bond ceases to exist and the investor becomes a shareholder. Convertible bonds generally offer lower interest rates than regular bonds due to their conversion feature.

If the bond remains unconverted at maturity the investor is repaid like any other bond. Investors have two choices: convert to shares for potential gains or hold the bond for fixed interest and a repayment of principal at maturity.

Characteristics of Convertible Bonds

• Conversion Option: Convertible bonds allow you to exchange your bonds for a specified number of issuing company shares. Depending on the conversion ratio and price this conversion can be exercised at a fixed date.
• Call and Put Options: Convertible bonds offer flexibility. Call options allow the issuer to buy back the bonds at a premium before maturity and put options will give the bondholder the right to sell the bond to the issuer at a fixed price.
• Conversion Ratio: It represents the number of shares an investor can receive up to conversion. For example a conversion of 20 allows each bond to be converted into 20 shares.
• Conversion Price: The price at which the bond is converted into shares is determined by dividing the bond’s par value by the conversion ratio. For example a Rs 1000 bond with a conversion ratio of 20 would have a conversion price of Rs 50.
• Lower Interest Rates: As conversion is a benefit convertible bonds generally offer lower interest rates than regular bonds.
• Maturity Date: Convertible bonds have a maturity date at which the principal amount is returned. This term generally spans from 5 to 10 years.

Different Types of Convertible Bonds

Companies issue different types of convertible bonds each with unique features and investor obligations.

1. Regular Convertible Bonds

• Investors can convert bonds into shares or hold them until maturity.
• These bonds offer periodic interest payments and a fixed maturity date.
• Investors redeem them either at face value or convert them into shares at a fixed price.
• Conversion of bonds is a right, not an obligation to investors providing flexibility.

2. Mandatory Convertible Bonds

• A specific date is established for the market participants to convert these bonds into shares.
• They pay a fixed coupon rate until the bond is converted into shares.
• Companies usually have to use high-yield bonds as these bonds come with a mandatory conversion.
• These bonds guarantee the issuance of shares thus aiding in raising capital without the fear of dilution.

3. Reverse Convertible Bonds

• The issuing company, not the investor, decides whether to convert the bond into shares or repay in cash.
• Conversion depends on stock price performance at maturity.
• Companies may choose to convert if stock prices are favourable or retain bonds if prices decline.
• These bonds make investors uncertain as they cannot control the conversion decision.

Additional Types of Convertible Bonds

1. Vanilla Convertible Bonds

• The most common type allows investors to convert or hold the bond until maturity.
• Investors convert if stock prices rise but hold if prices fall to receive the face value.

2. Mandatory Convertible Bonds

• Automatically convert into shares at a pre-set date removing investor discretion.
• Investors receive periodic interest until conversion but have no control over timing.

Reasons for Issuing Convertible Bonds

Companies issue convertible bonds as a strategic financing tool that combines debt with potential equity.

• Lower Interest Rates: Since investors have the option to convert to equity companies can offer lower coupon rates compared to regular bonds.
• Delayed Equity Dilution: Conversion happens later, helping avoid immediate dilution of ownership.
• Access to Capital: Attracts investors who are interested in both fixed returns and future equity gains.
• Improved Market Perception: Issuing convertibles may signal growth potential, enhancing investor confidence.

When is the Right Time to Convert a Convertible Bond ?

The right time to convert a convertible bond into equity depends on market conditions, stock performance and personal investment goals.

• Stock Price Above Conversion Price: If the current share price is significantly higher than the conversion price, converting can unlock capital gains.
• Bullish Market Trends: In a rising market converting early may lead to greater long-term returns.
• Approaching Maturity: If the bond is nearing maturity and the stock has appreciated, conversion may be more beneficial than redeeming it.
• Tax Planning: Converting in a low-tax year can reduce the impact of capital gains.
• Investment Objectives: If you prefer equity exposure and are optimistic about the company’s future, conversion aligns with your strategy.

Advantages of Convertible Bonds

Convertible bonds provide a mix of fixed-income stability and equity upside potential making them attractive to both investors and companies.

• Fixed Income with Equity Potential: Investors receive regular interest payments and have the option to convert the bond into equity for capital appreciation.
• Lower Coupon Rates for Issuers: Companies can raise capital at lower interest costs compared to traditional bonds, due to the conversion feature.
• Downside Protection: If the stock underperforms bondholders still benefit from fixed interest and principal repayment.
• Attractive to Risk-Averse Investors: These bonds appeal to investors seeking equity exposure with less risk.
• Flexibility in Capital Structure: Issuers can delay dilution until conversion occurs helping manage their financial strategy more effectively.

Disadvantages of Convertible Bonds

While convertible bonds offer flexibility, they come with certain drawbacks for both investors and issuers. Here’s a closer look:

• Lower Interest Rates: Convertible bonds typically offer lower coupon rates than regular bonds, as they include the option to convert into equity.
• Dilution of Equity: If converted, they increase the number of outstanding shares, which can dilute existing shareholders’ ownership.
• Market Risk: The value of convertible bonds is tied to the issuer’s stock price, making them susceptible to market volatility.
• Complex Valuation: Pricing convertible bonds can be complex due to their hybrid nature and dependency on interest rates and stock movements.
• Limited Upside for Investors: If the stock doesn’t perform well, the investor may end up with a lower return compared to traditional equity investments.

Conclusion

As with most investment options, convertible bonds also provide unique opportunities for investors. By analysing the issuer’s financial position and estimating the increase in stock value, this hybrid security can diversify portfolios and improve overall returns.