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Bonds

Companies issue corporate bonds to raise money to finance their operations. Corporate bonds are debt obligations of the issuer—the company that issued the bond. Most companies could borrow the money from a bank, but they view this as a more restrictive and expensive alternative than selling the debt on the open market through a bond issue.

Type of bonds

• Fixed rate bonds pay a fixed rate until maturity. Bondholders earn predictable return regardless of prevailing market conditions.
• Floating rate bonds do not pay a fixed rate as the interest rate varies. The interest rate is usually a fixed spread above EURIBOR.
• Zero coupon bonds do not pay periodic interest during their tenure. These bonds are issued at a discount and are repayable at par value.
• Convertible bonds give the right to convert the bond to a predefined number of equity shares in the issuing company at a particular time.

Before investing

Investors must consider several issues before investing in bonds, such as:

• Risk and Return: Bonds are not risk-free. In addition to inflation, interest, liquidity and default risk, investors should consider whether they prefer getting a higher return compared to investing in lower risk government bonds.
• Default risk: This is the biggest risk for investors. It includes the risk arising from the inability of the issuer to repay the principal to the bondholders. The default can also include interest payments. Therefore, it is advisable for investors to look into the financial statements of the issuer before investing in the bond.
• Liquidity: An important factor to consider is the liquidity of bonds and if investors have the ability to exit before maturity. Though bonds are traded in the secondary market, if exit terms are available, selling the bonds before maturity may cause a financial loss on the investor if there is no liquidity, or the price is significantly lower. You may also not be able to sell your investment when you wish.

Convertible Bonds

Companies issue convertible securities to raise money to finance their projects and to lower the rate on debt and delay dilution. A bond’s conversion ratio determines how many shares an investor will get. Companies can force conversion of the bonds if the stock price is higher than if the bond were to be redeemed.

Benefits for investors

Convertible securities offer investors the potential for equity-like appreciation while providing the downside risk protection of a fixed income instrument. An investor knows that the company will pay a fixed or variable interest until the trigger point, when the investor will have the option to either convert into shares of the company, usually at a discount, or walk away and ask for full repayment, according to the terms of issue.

Risks to consider

Investors and companies should understand that general market or industry specific changes can affect the company and possibly lower the value of its securities. Here’s how these deals tend to work and some of the risks they pose:

• The company issues convertible securities that allow the holders to convert their securities to equity at a discount to the market price at the time of conversion. If conditions change and the value of the shares is lower, then the company will be forced to issue more shares.
• The more shares the company issues on conversion, the greater the dilution to the company’s existing shareholders and to future shareholders, resulting in lower earnings per share and lower dividends.

Before you decide to invest in a company, you should find out what types of financings the company has engaged in – including convertible security deals – and make sure that you understand the effects those financings might have on the company and the value of its securities. It is advisable to seek the help of a professional before investing, if you do not fully understand the risks.