Convertible bonds

Definition

Convertible bonds are a type of debt security that can be converted into a predetermined number of the company's equity shares, usually at the discretion of the bondholder. This unique feature allows investors to benefit from potential price appreciation of the company's stock while still receiving regular interest payments. Convertible bonds combine characteristics of both debt and equity, providing flexibility and potentially lower borrowing costs for the issuing company.

5 Must Know Facts For Your Next Test

1. Convertible bonds typically offer lower interest rates compared to traditional bonds because of the added benefit of conversion into equity.
2. The conversion price is set at issuance and determines how many shares a bondholder will receive upon converting their bond.
3. Investors may choose to convert their bonds into equity if they believe the company's stock price will rise significantly above the conversion price.
4. Convertible bonds can help companies raise capital with less dilution of ownership compared to issuing new equity directly.
5. In times of financial distress, convertible bonds may provide a safety net for investors, as they still receive interest payments until conversion.

Review Questions

• How do convertible bonds provide advantages for both issuers and investors?
  • Convertible bonds benefit issuers by allowing them to borrow at lower interest rates while also reducing immediate dilution of ownership since conversion occurs later. For investors, these bonds offer a fixed income stream from interest payments and the opportunity to convert to equity if the company performs well. This dual benefit creates an attractive investment vehicle that aligns the interests of both parties.
• Evaluate how changes in stock prices impact the attractiveness of convertible bonds as an investment option.
  • When stock prices rise significantly above the conversion price, convertible bonds become more attractive as investors can convert their bonds into shares for profit. Conversely, if stock prices fall, the appeal diminishes since investors may prefer holding onto their bonds for interest payments rather than converting to depreciated shares. This dynamic illustrates how market conditions can influence investor decisions regarding convertible bonds.
• Analyze the role of convertible bonds in a company's capital structure and their effect on long-term financial strategy.
  • Convertible bonds play a crucial role in a company's capital structure by providing a flexible financing option that minimizes immediate dilution while allowing for potential equity conversion later. This strategy enables companies to attract investors seeking both fixed income and equity upside without significant upfront costs. By effectively managing convertible debt, companies can optimize their financing mix and position themselves for growth, balancing short-term obligations with long-term equity interests.

Related terms

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

interest rate risk:

The risk that changes in interest rates will affect the value of fixed-income investments, including bonds.

equity financing: The process of raising capital through the sale of shares in a company, which represents ownership in that company.