Convertible bonds

Definition

Convertible bonds are hybrid securities that combine features of both debt and equity, allowing bondholders the option to convert their bonds into a predetermined number of shares of the issuing company's stock. This conversion feature provides investors with the potential for equity upside while still receiving fixed interest payments, making them an attractive investment for those seeking growth opportunities without sacrificing income.

5 Must Know Facts For Your Next Test

1. Convertible bonds typically offer lower interest rates compared to regular bonds because of the added value from the conversion option.
2. The conversion ratio determines how many shares a bondholder will receive upon converting their bonds into stock.
3. Investors may prefer convertible bonds during periods of market volatility as they provide a cushion in the form of fixed interest payments while retaining potential upside if the company performs well.
4. If the issuing company's stock price rises above the conversion price, bondholders may choose to convert their bonds into shares to capitalize on the increase in value.
5. Convertible bonds can enhance a company's capital structure by attracting investors who may be more cautious about investing directly in equities.

Review Questions

• How do convertible bonds serve as a bridge between debt and equity, and what are some advantages for investors?
  • Convertible bonds act as a bridge between debt and equity by offering fixed interest payments like traditional bonds while also providing the option to convert into shares of stock. This unique feature allows investors to enjoy steady income while having the opportunity to benefit from potential stock price appreciation. The flexibility of converting can be particularly appealing during periods of market growth, allowing investors to take advantage of both fixed income and equity market returns.
• Discuss how the conversion feature of convertible bonds can impact a company's capital structure and investor perception.
  • The conversion feature of convertible bonds can significantly affect a company's capital structure by potentially increasing its equity base if bondholders convert their bonds into shares. This can dilute existing shareholders' ownership but can also strengthen the balance sheet by reducing debt levels. Investor perception may improve as convertible bonds signal confidence in the company's future growth prospects, attracting a diverse group of investors looking for both stability and growth potential.
• Evaluate how changes in market conditions might influence the attractiveness of convertible bonds for both issuers and investors.
  • Market conditions play a crucial role in determining the attractiveness of convertible bonds. In a rising market where stock prices are expected to increase, these bonds become appealing for investors seeking capital gains through conversion. Conversely, if market conditions deteriorate and stock prices decline, investors may prefer traditional fixed-income investments for their safety. For issuers, issuing convertible bonds during bullish periods can provide capital at lower interest rates while limiting dilution, but during bearish periods, they may face challenges in attracting investors due to heightened risk aversion.

Related terms

debenture: A type of unsecured bond that relies on the creditworthiness and reputation of the issuer rather than collateral.

equity:

Ownership interest in a company, represented by shares of stock, which typically includes voting rights and potential dividends.

call provision: A feature of certain bonds that allows the issuer to redeem them before their maturity date at specified terms, usually at a premium.