Among the various investment options available to an investor, corporate bonds are one of the most highly sought after instruments. Bonds are a great way for a company to raise capital since they’re not bound by tight regulatory requirements. And from the investors’ perspective, corporate bonds are a good way to earn a fixed-rate of return that’s generally higher than what most banks offer. Apart from regular bonds, companies also occasionally offer something called convertible bonds. If you’re looking for the convertible bond’s meaning, here’s everything that you need to know.
What is a convertible bond?
A convertible bond is a hybrid corporate debt security that comes with both debt and equity components. Unlike regular bonds that are redeemed upon maturity, a convertible bond gives the purchaser a right or an obligation to convert the bond into shares of the issuing company. The quantum of shares and the value of the shares are usually predetermined by the issuing company.
However, an investor can convert the bond into stock only at certain specified times during the bond’s tenure. In all other aspects, a convertible bond is highly similar to a regular corporate bond. It features a fixed tenure and pays out interest payments periodically at predetermined intervals. If an investor chooses not to convert the bond to equity shares, he would automatically be entitled to receive the bond’s face value upon maturity.
Types of convertible bonds
Now that you’re clear with respect to the convertible bond’s meaning, let’s move onto the different types of convertible bonds that companies usually offer. Here’s an in-depth look at them.
Regular convertible bonds
Companies generally prefer to issue these types of convertible bonds to the public. Regular convertible bonds come with a fixed maturity date and a predetermined conversion price. In exchange for investing in these bonds, the issuing company makes periodic interest payments to the investors till the date of maturity.
Upon maturity, the investor may either choose to convert the bonds to equity shares of the issuing company at the predetermined conversion price or redeem the bonds at their face value. These bonds merely give the investor the right, and not an obligation, to convert.
Mandatory convertible bonds
Unlike regular convertible bonds, these bonds obligate the investor to convert them into equity shares of the issuing company upon maturity. Mandatory convertible bonds also make regular interest payments till the date of maturity, upon which the bonds are to be compulsorily converted to equity shares. Since investors are essentially forced to convert their bonds, companies usually offer a higher rate of interest on mandatory convertible bonds.
Reverse convertible bonds
The right or the obligation of conversion falls on the investor or the bond holder with respect to both regular and mandatory convertible bonds. With reverse convertible bonds, however, the issuing company holds the right to convert them into equity shares upon maturity at a predetermined conversion price. Depending on the prevailing circumstances and the share price at the time of maturity, the issuing company may choose to either convert the bonds into equity shares or retain them as such.
What are the advantages of convertible bonds?
Convertible bonds come with a couple of advantages for both the investor and the issuing company. Let’s delve a little deeper into them.
For the investor
By subscribing to convertible bonds, investors get to enjoy dual-benefits. In addition to receiving a fixed rate of interest on their investments till the time of maturity, investors also get to enjoy the benefits of stock value appreciation.
In addition to this, investors of convertible bonds also enjoy lower levels of default risk. In the event of liquidation of the issuing company, bond holders tend to get first preference on the liquidation proceeds of the company. Since their investments are essentially guaranteed to a certain extent, the risk of default is reduced.
For the issuing company
The issuing company gets to raise capital right away without having to dilute their shares immediately, which is the case with respect to equity financing. By issuing convertible bonds, the company can technically put off share dilution to a later point in time.
Since the investor gets to take part in the share value appreciation process, issuing companies generally offer a slightly lower rate of interest on convertible bonds when compared to the rate on traditional corporate debt securities.
Although convertible bonds sound like a great way to earn high returns on your investment, it is still essential for you to conduct a thorough analysis of the issuing company before choosing to subscribe for their bonds. Always ensure that you’re investing in a financially sound company that is capable of meeting its debt requirements when they fall due. Also, make sure that you take a good look at the company’s credit ratings before purchasing their bonds.