Convertible Bonds as an Investment Instrument
A convertible bond is a financial instrument that has a long maturity. The term may range between 25 and 30 years, but some securities have a shorter term. Holders can acquire common shares directly from the issuer. In comparison with traditional investment instruments, convertible securities have two more elements – conversion ratio and price. The conversion ratio is used to calculate the number of stocks holders receive per bond. The conversion price is the price holders pay for common shares.
The bond can be converted into a pre-agreed amount of shares or equity during specified times. This can happen at the bondholder’s discretion. The bond indenture details the terms and conditions of the exchange.
What Are the Benefits
Companies offer this type of security to reduce negative interpretations on the part of investors about their corporate policies and actions. When publicly traded companies issue stock, this is an indication of price overvaluation. A company may issue convertible securities in this case, which can be converted into equity. They can increase in price when the company’s stock is performing well. The security cannot be converted if the stock performs poorly. Companies also benefit from issuing convertible bonds because this allows them to raise money for their operations. The interest payment is lower, and the debt is eliminated when the security is converted into stock. Companies that issue bonds benefit in other ways. Interest is considered a deductible expense meaning that the government pays a certain percentage of the interest charges. This is one advantage of convertible securities over preferred and common stock.
What Are the Downsides
There are some downsides to investing in convertible bonds. In case of default or bankruptcy, bondholders may incur losses. Another problem is that investors who buy non-convertible securities have a higher priority to claim assets in case of bankruptcy. Another issue is that convertible securities are callable in most cases. This means that issuers can call them away, and their earning potential is more limited. There are advantages to investing in convertible bonds as well, one being that the prices are competitive. Bondholders collect interest until they convert the security into stock. Companies offer bonds at low coupon rates meaning that investors pay less than what they would otherwise pay for straight bonds. Bondholders enjoy a limited but fixed income until the security is converted.
The issuing company uses the funds as operating income. If it performs well, the new shareholders receive a percentage of the operating income. There is a difference between common and converted shareholders, however. The former have the right to vote while the latter are not entitled. Thus only common shareholders have voting control.
Note that businesses with bad credit also issue convertible securities. The main goal is to sell securities by reducing the yield. This is done to lower the cost of financing. The problem with financially weak businesses is that the bonds they issue cannot be converted. To benefit the most, investors should wait for the stock to reach its conversion price. Moreover, this debt security is considered subordinated debt. This means that bondholders would receive their credit only after senior debt holders have been paid.
For companies, the downsides are similar to those of other types of debt. The risk is higher for bonds with a shorter maturity. Stockholders face a higher risk when using fixed-income securities, especially when earnings and profits decline. At the same time, start-up businesses prefer this debt instrument because it is a cost-effective way of financing. Convertible securities may be the only option for start-ups. Most financial institutions are unwilling to offer financing to new businesses.
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