Convertible bonds

Definition

Convertible bonds are a type of debt security that can be converted into a predetermined number of shares of the issuing company's stock, usually at the discretion of the bondholder. This feature allows investors to benefit from potential appreciation in the company's stock while providing the fixed income characteristic of traditional bonds.

5 Must Know Facts For Your Next Test

1. Convertible bonds typically offer lower interest rates than regular bonds because of the added benefit of conversion to equity.
2. When convertible bonds are converted into stock, the liability on the balance sheet decreases while equity increases.
3. The conversion ratio determines how many shares of stock a bondholder receives upon conversion, which is specified in the bond's terms.
4. Investors in convertible bonds are often seeking both income from interest payments and potential capital appreciation from the stock.
5. If the issuing company's stock price increases significantly, bondholders may choose to convert their bonds to take advantage of higher equity value.

Review Questions

• How do convertible bonds differ from traditional bonds in terms of investor benefits and risks?
  • Convertible bonds differ from traditional bonds primarily through their conversion feature, which allows investors to convert debt into equity. While traditional bonds provide fixed interest payments and return of principal at maturity, convertible bonds offer potential for capital appreciation if the company's stock performs well. However, this comes with additional risk; if the company's performance falters, bondholders may end up with less value than anticipated compared to holding traditional bonds.
• Analyze how the issuance of convertible bonds affects a company's balance sheet and its financial ratios.
  • When a company issues convertible bonds, it initially records a liability on its balance sheet. This affects financial ratios such as debt-to-equity and interest coverage ratios, potentially making the company appear more leveraged. Upon conversion, the liability decreases as it is replaced with equity, positively impacting the debt-to-equity ratio and improving the company's overall leverage position. The impact on these ratios can influence investor perceptions and decisions regarding company stability and growth potential.
• Evaluate the strategic reasons a company might choose to issue convertible bonds instead of traditional debt instruments.
  • A company may choose to issue convertible bonds as a strategy to attract investors seeking both income and growth potential without immediately diluting equity. This can be particularly advantageous for companies with growth prospects, as it allows them to offer lower interest rates due to the conversion feature. Additionally, issuing convertible bonds can provide companies with immediate capital while deferring potential dilution until conversion occurs, allowing them time to enhance their stock value and performance before any equity increase takes place.

Related terms

bond:

A bond is a fixed income instrument that represents a loan made by an investor to a borrower, typically corporate or governmental.

debenture:

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

stock options: Stock options are contracts that give the holder the right, but not the obligation, to buy or sell a stock at a specified price within a certain timeframe.