Convertible bonds

Definition

Convertible bonds are hybrid securities that allow bondholders to convert their bonds into a predetermined number of shares of the issuing company's stock at specific times during the bond's life. This feature provides investors with the potential for capital appreciation through equity participation, while also offering the safety of fixed-income investments. Convertible bonds can impact a company's capital structure and are often used as a means of raising capital, making them a key financial instrument in corporate finance.

5 Must Know Facts For Your Next Test

1. Convertible bonds typically offer lower interest rates than traditional bonds due to the added value of the conversion feature.
2. When a convertible bond is converted into stock, it can dilute existing shareholders' equity, impacting the company’s overall capital structure.
3. Investors are often attracted to convertible bonds for their potential upside in rising markets while still having downside protection from fixed interest payments.
4. Convertible bonds can be structured with varying conversion ratios and terms, allowing companies flexibility in how they manage their capital and debt levels.
5. In times of market volatility, convertible bonds may provide more stability compared to stocks, making them an appealing option for conservative investors.

Review Questions

• How do convertible bonds serve as a hybrid investment option for investors?
  • Convertible bonds serve as a hybrid investment because they combine features of both debt and equity. Investors receive fixed interest payments like traditional bonds, providing safety and predictable income. However, they also have the opportunity to convert their bonds into stock, allowing them to benefit from any potential appreciation in the company's share price. This blend offers a unique risk-return profile that attracts various types of investors.
• Discuss the implications of issuing convertible bonds on a company's capital structure and leverage.
  • Issuing convertible bonds can significantly impact a company's capital structure and leverage. When these bonds are converted into equity, it results in an increase in shareholder equity and may lead to dilution of existing shares. Additionally, while convertible bonds initially increase leverage due to their classification as debt, the eventual conversion can reduce overall debt levels. This dual effect can help companies manage their financing strategies effectively by balancing between debt and equity financing.
• Evaluate the strategic reasons a company might have for choosing to issue convertible bonds over traditional debt or equity.
  • Companies may choose to issue convertible bonds over traditional debt or equity for several strategic reasons. Firstly, convertible bonds often come with lower interest rates than conventional debt due to their conversion feature, which makes them more attractive to issuers seeking cheaper financing. Secondly, they provide a way to raise capital without immediate dilution of equity, as conversion occurs at a later date. Lastly, by offering investors potential upside through conversion, companies can appeal to a broader investor base while maintaining flexibility in their capital structure.

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.

equity financing: The process of raising capital by selling shares of stock in the company, providing investors with ownership stakes in exchange for their investment.

warrant: A financial instrument that gives the holder the right to purchase shares of stock at a specific price before a certain expiration date, often used to sweeten the terms of a bond issue.