Convertible bonds are distributed by a corporation, but not like a regular bond the convertible bond provides the bondholder the choice to trade in the bond for a number of shares in the company that distributed it. Basically the bond holder has an income investment that is fixed with an interest payment in addition to a possible benefit due to an increase in the company’s price per share. The added value of the conversion option of the bond means that the coupon payment or interest on the each bond will be lower than a comparable bond that does not have a conversion plan attached.
Convertible bonds, similar to some other types of bonds, will express the maturity and the interest on the bond. However, unlike other bonds convertible bonds will also include information about the conversion option or how many shares will be received by the bond holder if the bond is converted.
An example would be one convertible bond selling for $1000. The bond contains an annual coupon of 8% and can be converted to 100 shares at any given time. Every year a bondholder receives $80 (8% X $1000) provided that the bond has not been transformed as shares. If the bondholder does convert the bond to shares in the corporation the interest will no longer be received for the bond and the value of the investment would change to the stock price at the time of conversion.
Convertible bonds can be a great investment for low risk investors that want to get the returns of the stock market, but with the risk of a bond. There are pros and cons for both the bondholder and the issuer for convertible bonds.
Pros and cons seen for convertible bonds as the issuer
The issuer has the ability to get a much lower fixed costs in order to borrow. Distributing a debt with a conversion premium that is more than market values is much more desirable for an issuer than having to pay a higher price for a capital for a senior debt that happens to be fixed or having to issue equity below or at market values.
Issuers have the option of attaching additional conditions that create more appeal for these bonds to issuers for a resource of capital and not as much for investors, such as a feature that permits the issuer to call the bond if the company would start to increase earnings. The feature to call is usually issued with the company stock prices rise more rapidly than the company anticipated. The call feature does permit the issuer to compel the holder of a bond to convert bonds at a loss or price lower than a bondholder would sometimes like. Therefore, it is extremely important as a bondholder you read a bond contract thoroughly before deciding to purchase convertible bonds.
A key disadvantage for the convertible bond issuer can be the stock prices rapidly increasing following the bonds issue and conversion happens in a short period of time following issue. This scenario usually means the company valued itself very ineffectively. One other scenario that isn’t good for a company issuing convertible bonds is the common stock moving lower after the bond is issued. In this event, the holder of a bond won’t convert to equity like an issuer would hope, but continued to gain interest in addition to recovering their principal.
Pros and cons for the bondholder
Convertible bonds can be a much safer or low risk investment than purchasing regular stock on the market. However, convertible bonds can provide returns as high as many stock investments. Convertible bonds may have the possibilities of stock returns without the volatility. The value of the bonds can only decrease to the return that is the same as a bond that cannot be converted that is the same term. These bonds are very strong during a bear market at the same time allowing an investor to participate in the profits as a company’s stock increases.
Disadvantages of the convertible bond for the bondholder are receiving substantially lower returns to maturity when compared with their equivalent that is non-convertible. Concern is only seen when the issuer’s equity does not make the rising price forecasts that would make accepting a lower interest speculation worthwhile.
A call feature tied to any convertible bond may be a downside for a bondholder in some cases. The company can make the holder of a bond give the bond up at a markdown to market if they desire. A call provision is never an upside to a bondholder and is one of the best safety nets for the company when dealing with convertible bonds.
Considerations when determining if a convertible bond is right for your investments
A convertible bond will provide an investor with an investment device that has much lower risks and poorer yields than a similar investment that may not be convertible, but will allow the investor a slight benefit of a higher stock price for a company. The bondholder is producing a tradeoff with this type of low risk investment; lower interest rates or returns upfront with expected increases in the stock price of a corporation. If the projected stock price gains remain to be seen, a convertible bondholder will have lost the interest difference offered by the convertible bond and the non-convertible equivalent. In addition, if the bond has a call provision and the corporation does utilize it because of unanticipated increase in stock prices the bondholder may have missed out on a very large return for their investment.
When deciding to invest in convertible bonds research should be done for the company or issuer of the bonds to make an informed decision in determining where the company and stock prices may be headed in the future or at least the foreseeable future of the bonds. The quality of a company’s credit should also be assessed. Ensure the company is strong enough to withstand the economic downturns of the economy. Find out what the potential to grow of the company stock is projected by financial experts to be and if it is enough to reward you for a lower yield found with the convertible bond.
Although convertible bonds are touted as low risk investments, there are still many risks involved that investors do not see with certificates of deposit or CDs, money market accounts or traditional savings.