Convertible bond

Definition

A convertible bond is a type of debt security that can be converted into a predetermined number of shares of the issuing company's stock at certain times during its life. This feature provides investors with the potential for capital appreciation if the company's stock performs well, while still offering the regular interest payments typical of bonds. Convertible bonds combine elements of both fixed-income investments and equity, making them unique in the bond market.

5 Must Know Facts For Your Next Test

1. Convertible bonds generally offer lower interest rates than regular bonds because of the added value of the conversion option.
2. Investors can convert their bonds into shares, usually at a set conversion price, which can lead to potential capital gains if the stock price rises above that level.
3. The conversion ratio determines how many shares an investor will receive for each bond converted, which is specified in the bond’s terms.
4. Convertible bonds are attractive during periods of rising stock prices as they provide a safety net of fixed interest payments while allowing participation in equity upside.
5. They can also impact a company's balance sheet; if too many bonds are converted, it may dilute existing shareholders’ equity.

Review Questions

• How does the conversion feature of convertible bonds provide benefits to investors compared to traditional bonds?
  • The conversion feature allows investors to potentially benefit from capital appreciation if the issuing company's stock price rises significantly. While traditional bonds only offer fixed interest payments, convertible bonds provide an additional opportunity for profit by converting to stock at a favorable price. This hybrid nature makes them appealing for investors seeking both income and growth potential, particularly in bullish market conditions.
• Discuss the implications of issuing convertible bonds for a company's financial structure and its existing shareholders.
  • Issuing convertible bonds can help a company raise capital with lower interest costs due to their attractive features. However, if many bondholders choose to convert their bonds into equity, it may lead to dilution of existing shareholders' ownership percentage. This dilution occurs because more shares enter the market, potentially affecting stock value and control dynamics within the company. Companies must weigh these trade-offs when considering convertible debt as a financing option.
• Evaluate the role of market conditions in determining the attractiveness of convertible bonds versus other investment options.
  • Market conditions play a critical role in the attractiveness of convertible bonds. In bull markets where stock prices are rising, investors may favor convertible bonds for their dual benefit of interest income and potential equity upside. Conversely, in bear markets or periods of economic uncertainty, these bonds might become less attractive compared to safer fixed-income securities or high-yield stocks. Understanding investor sentiment and market trends is key for assessing how well convertible bonds will perform relative to other options available.

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.

stock: Stock represents ownership in a company and constitutes a claim on part of the company’s assets and earnings.

debenture: A debenture is a type of debt instrument that is not backed by physical assets or collateral but is secured by the general creditworthiness and reputation of the issuer.