Convertible bonds

Definition

Convertible bonds are a type of fixed income security that allows the bondholder to convert their bonds into a predetermined number of shares of the issuing company’s stock, usually at specific times during the bond's life. This feature gives investors the opportunity to participate in the company's equity upside while still receiving regular interest payments, making convertible bonds an attractive option for those seeking a balance between fixed income and equity-like returns.

5 Must Know Facts For Your Next Test

1. Convertible bonds typically offer lower interest rates compared to non-convertible bonds because of their added value from the conversion feature.
2. The conversion ratio determines how many shares a bondholder receives upon conversion, which is established when the bond is issued.
3. Investors may prefer convertible bonds in volatile markets as they provide downside protection through fixed income while allowing for upside potential through stock conversion.
4. The price of convertible bonds can be influenced by the underlying stock price; as stock prices rise, so does the attractiveness of converting bonds into shares.
5. Convertible bonds can be advantageous for companies as they often have less immediate cash outflow compared to issuing straight equity or other types of debt.

Review Questions

• How does the conversion feature of convertible bonds provide a unique investment opportunity compared to traditional bonds?
  • The conversion feature allows investors to exchange their bonds for shares in the issuing company, which provides a way to benefit from potential stock price appreciation. Unlike traditional bonds that only pay interest, convertible bonds give investors both fixed income security and an opportunity to participate in equity gains if the company's stock performs well. This dual characteristic makes them particularly appealing in dynamic market conditions.
• Discuss how changes in interest rates might affect the pricing and attractiveness of convertible bonds versus other fixed income securities.
  • When interest rates rise, the prices of existing fixed income securities generally fall due to new bonds being issued at higher rates. However, for convertible bonds, their value might not decline as much since they offer conversion into equity, which could become more attractive if stock prices increase. Thus, while both types are affected by interest rate changes, convertible bonds can retain more value due to their potential for equity participation.
• Evaluate the implications of using convertible bonds as a financing strategy for companies, considering both benefits and potential drawbacks.
  • Using convertible bonds as a financing strategy offers several benefits for companies, such as lower interest costs compared to straight debt and less immediate dilution of equity. However, there are potential drawbacks as well; if the company’s stock performs well, it may face significant dilution when bondholders convert their holdings into shares. Furthermore, convertible bonds can add complexity to capital structure management as companies need to balance debt obligations with equity interests from conversions.

Related terms

debenture: A debenture is a type of long-term debt instrument that is not secured by physical assets or collateral, relying instead on the creditworthiness and reputation of the issuer.

bond indenture: A bond indenture is a legal contract between the bond issuer and bondholders that outlines the specific terms and conditions of the bond, including interest rates, maturity dates, and conversion features.

equity financing: Equity financing involves raising capital through the sale of shares in the company, providing investors with ownership stakes and potential dividends.