Nicosia – Convertible bonds are bonds that are issued by legal entities or corporations that can be converted into the shares of the issuing company’s stock or in some cases, the shares of another company with whom the issuer of the bonds has an agreement.
Convertible bonds are popular since they pay a regular return via coupon payments, but at the same time they give the right or the option to the bondholder to own the shares of the underlying company at a later date, or simply allow the bonds to expire and receive full payment of capital invested.
The price of the convertible bond may increase sharply in cases when the strike price at which the convertibles are converted into shares is significantly lower than current market price of the underlying shares, when such shares are publicly traded.
Investors must evaluate the risk of investing, since as with all other corporate bonds, there is always the risk that the legal entity which issued the bonds may default. Before making an investment, investors must check that the issuer is a mature, established business with strong and well-established management team, has positive cashflow to make sure that it can pay the promised coupon and generally has sound financial position.
Why do companies issue convertible bonds?
Companies issue convertible bonds for two main reasons according to Investopedia. The first is to lower the coupon rate on debt. Investors will generally accept a lower coupon rate on a convertible bond, compared with the coupon rate on an otherwise identical regular bond, because of its conversion feature. This enables the issuer to save on interest expenses, which can be substantial in the case of a large bond issue.
The second reason is to delay dilution. Raising capital through issuing convertible bonds rather than equity allows the issuer to delay dilution to its equity holders.
One downside of convertible bonds is that the issuing company has the right to call the bonds. In other words, the company has the right to forcibly convert them.
The Bond can be converted during the bond’s lifetime by the bondholder whenever the issuing company has any private or public share offering or according to the terms of issue.
If the bondholder does not convert their bonds and no mandatory conversion occurs, the bond matures at the end of its lifetime. The issuing company then pays the bondholder the principal amount invested.