Convertible Bonds

Definition

Convertible bonds are a type of debt security that allows the bondholder to convert their bonds into a predetermined number of shares of the issuing company's stock. This feature provides investors with the potential for capital appreciation if the company’s stock performs well while also offering the security of fixed interest payments until conversion.

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 of the conversion feature.
2. When the market price of the company’s stock exceeds the conversion price, bondholders are more likely to convert their bonds into shares.
3. The issuance of convertible bonds can be an attractive financing option for companies looking to minimize immediate cash outflows while still raising capital.
4. Convertible bonds may dilute existing shareholders' equity when converted, as more shares are added to the total outstanding shares.
5. Investors in convertible bonds must evaluate both the bond's fixed income characteristics and the potential for equity gains when making investment decisions.

Review Questions

• How do convertible bonds provide a unique investment opportunity compared to traditional bonds?
  • Convertible bonds offer a blend of fixed income and equity potential, which distinguishes them from traditional bonds. While they provide regular interest payments similar to typical debt securities, the ability to convert into shares allows investors to benefit from increases in the company's stock price. This dual nature makes convertible bonds appealing for those looking to balance income with potential growth in their investment portfolio.
• Evaluate how the conversion feature in convertible bonds impacts a company's capital structure and existing shareholders.
  • The conversion feature of convertible bonds can significantly affect a company's capital structure by introducing additional equity when bondholders decide to convert their bonds into stock. This can lead to dilution of existing shareholders' equity since more shares will be outstanding after conversion. While this may strengthen the company's balance sheet by reducing debt obligations, it also requires careful consideration of how it influences shareholder value and voting power.
• Assess the implications of interest rate movements on the attractiveness of convertible bonds as an investment option.
  • Interest rate fluctuations can greatly impact the appeal of convertible bonds. When interest rates rise, newly issued bonds may offer higher yields, making existing lower-rate convertible bonds less attractive. Conversely, if interest rates fall, the fixed interest payments from these convertible bonds may become more valuable relative to other investments. Additionally, if stock prices increase significantly, bondholders may be incentivized to convert their holdings into equity, shifting the focus from fixed income to capital gains.

Related terms

Debt Security: A financial instrument that represents a loan made by an investor to a borrower, typically involving fixed interest payments and repayment of principal at maturity.

Equity:

Ownership interest in a company, represented by shares of stock, which entitles shareholders to vote on corporate matters and receive dividends.

Conversion Ratio: The number of shares of stock that each convertible bond can be converted into, established at the time of issuance.