Convertible bonds

Definition

Convertible bonds are hybrid securities that combine features of both debt and equity, allowing bondholders to convert their bonds into a predetermined number of shares of the issuing company's stock at specific times during the bond's life. This feature provides investors with the potential for capital appreciation while still receiving fixed interest payments, making them attractive in fluctuating markets.

5 Must Know Facts For Your Next Test

1. Convertible bonds typically offer lower interest rates compared to traditional bonds due to the added value of the conversion option.
2. The conversion price is set at issuance and is usually higher than the current stock price, incentivizing conversion when the company's stock performs well.
3. Investors may benefit from bond features like fixed interest payments while having the potential upside of stock ownership.
4. The ability to convert bonds into equity can dilute existing shareholders' ownership percentage if many bondholders choose to convert.
5. Convertible bonds are often issued by growth companies that expect their stock prices to rise significantly, making them a strategic financing tool.

Review Questions

• How do convertible bonds provide benefits to both issuers and investors in terms of financing and investment strategy?
  • Convertible bonds offer issuers a way to raise capital with lower interest rates since investors value the conversion option. For investors, these bonds provide fixed income and potential equity upside if the company's stock performs well. This dual appeal makes convertible bonds an attractive choice for both parties, as they allow companies to finance growth while giving investors exposure to equity gains.
• Discuss the impact of convertible bonds on a company's capital structure and shareholder equity when many bondholders choose to convert their bonds into stock.
  • When bondholders convert their convertible bonds into stock, it increases the number of shares outstanding, leading to potential dilution of existing shareholders' equity. This change can affect earnings per share (EPS) and overall shareholder value. Additionally, as more debt is converted into equity, it alters the company's capital structure, reducing debt obligations and potentially improving its credit profile.
• Evaluate the role of convertible bonds in international financial markets and how they adapt to various economic conditions globally.
  • Convertible bonds play a significant role in international financial markets by offering companies a flexible financing option that can be attractive during periods of uncertainty or volatility. In differing economic climates, these securities allow investors to hedge against risks while capturing upside potential. As global markets fluctuate, convertible bonds can adapt by appealing to diverse investor bases looking for income and growth opportunities amid changing interest rates and market sentiments.

Related terms

bond: A fixed income instrument that represents a loan made by an investor to a borrower, typically corporate or governmental.

equity: Ownership interest in a company represented by shares of stock, which entitles the shareholder to a portion of the company's profits and assets.

callable bonds: Bonds that can be redeemed by the issuer before their maturity date at a specified call price, often affecting their interest rates and investor returns.