Features of Convertible Bond

Convertible bonds have interest payments attached to them and are issued by corporations. Converting a bond into stock may be done at various points over the bond's life, but it is often up to the bondholder to decide when and how to make the conversion. The price of a convertible bond is extremely sensitive to changes in interest rates, the price of the underlying stock, and the issuer's credit rating since it is a hybrid asset that considers these factors.

Acquiring Knowledge about Convertible Bonds

Companies have more financing options in the form of convertible bonds. Investors are provided with hybrid security called a convertible bond. This type of security contains characteristics of both bonds and stocks, such as interest payments and the possibility to buy the underlying stock. The number of shares of stock that may be obtained through the conversion of one bond is determined by the bond's conversion ratio. For instance, if the ratio is 5:1, it indicates that purchasing one bond would result in the acquisition of five shares of common stock.

Types of Convertible Bonds

The investor in a vanilla convertible bond can keep the bond till maturity or convert it into stock at any time throughout the holding period. The optimal time for an investor to convert a bond into stock is when the gain from the sale of the shares is more than the sum of the face value of the bond plus the entire amount of interest payments that are still outstanding.

Investors in mandatory convertible bonds are subject to the requirement that they convert their holdings at a specified price level and conversion ratio. On the other hand, a corporation with reversible convertible bonds can either convert the bond into equity shares or continue holding the bond as a fixed income investment until the bond reaches maturity. If the bond is converted, the conversion will occur at a predetermined price and conversion ratio.

Convertible Bonds Pros and Cons

When corporations issue convertible bonds, it may assist mitigate the unfavorable attitude among investors that might otherwise accompany the issuing of shares. When a corporation issues extra shares or equity, the total number of shares already in circulation increases, diluting the existing investor ownership. To counteract the unfavorable public opinion, the corporation could issue convertible bonds. If the firm is successful, bondholders will have the opportunity to convert their holdings into equity shares.

A fledgling business, for instance, may be working on a project that calls for a considerable amount of money, which would cause the firm to incur a revenue shortfall shortly. Nevertheless, the endeavor ought to eventually increase the organization's profitability. Investors in convertible bonds can recoup a portion of their initial investment if the issuing company goes bankrupt while also having the possibility of realizing capital gains if the issuing company is successful and the bonds are converted into equity.

Convertible bonds are simply bonds that come with a stock option, more specifically, a call option, which means that investors may benefit from the value-added component embedded into the bonds. An agreement is considered a call option if it provides the buyer with the right but not the duty to purchase a security (such as a stock, bond, or another instrument) at a certain price within a predetermined time frame. However, convertible bonds often have a lower coupon rate or rate of return in exchange for the value of the option to convert the bond into common stock. This is because convertible bonds are valued more for their ability to be converted into common stock.

Pros

• Investors get interest payments at a predetermined rate, and they can convert their money into company shares so that they may profit from the price increase of the stock.
• Because bondholders are paid before ordinary shareholders, investors are afforded a certain degree of protection against the possibility of a default.
• Raising cash without immediately diluting their shareholdings is beneficial to companies.
• When opposed to the use of conventional bonds, the use of corporate debt may result in the payment of cheaper interest rates.

Cons

• They provide a reduced coupon rate because the bond may be converted into common stock at the investor's choosing.
• Investors in convertible bonds take on extra risk when dealing with issuing firms with little or no historical profits, such as startups.
• If the bonds are converted into stock shares, share dilution may harm both the share price and the EPS dynamics.

The Conversion of a Bond as an Example

Consider the following scenario as an illustration: Exxon Mobil Corporation (XOM) has just issued a convertible bond with a face value of $1,000 and an interest rate of 4%. The bond duration is ten years, and the convertible ratio is one hundred shares of common stock for each convertible bond.