What is a Convertible Bond?
A convertible bond is a type of debt security that provides an investor with a right or an obligation to exchange the bond for a predetermined number of shares in the issuing company at certain times of a bond’s lifetime. A convertible bond is a hybrid security that possesses the features of both debt and equity.
Similar to regular bonds, a convertible bond comes with a maturity date and pays interest to investors. In addition, if an investor decides not to convert their bonds to equity, they will receive the bond’s face value at the maturity. However, if an investor converts the bonds to the company’s shares, the bonds will lose all its debt features and will possess only equity features.
Companies with a low credit rating and high growth potential often issue convertible bonds. For financing purposes, the bonds offer more flexibility than regular bonds. They may be more attractive to investors since convertible bonds provide a growth potential through future capital appreciation of the stock price.
Types of convertible bonds
There is no formal classification of convertible bonds in the financial markets. However, underwriters often refer to several types of convertible bonds:
1. Vanilla convertible bonds
They are the most common type of convertible bonds. Investors are granted the right to convert their bonds to a certain number of shares at a predetermined conversion price and conversion rate at the maturity date. Vanilla convertible bonds may pay coupon payments during the life of the bonds and comes with a fixed maturity date at which the investors are entitled to the nominal value of the bond.
2. Mandatory convertibles
Mandatory convertible bonds provide investors with an obligation to convert their bonds to the shares at maturity. The bonds usually come with two conversion prices: the first price would delimit the price in which an investor would receive the equivalent of its par value in shares; the second price would set a limit to the price that the investor would receive more than the par value.
3. Reverse convertibles
Reverse convertible bonds give the issuer an option to either buy back a bond in cash or convert a bond to the equity at a predetermined conversion price and conversion rate at the maturity date.
Advantages of convertible bonds
Convertible bonds are a flexible option of financing that offers some advantages over regular debt or equity financing. Few benefits from the issuance of convertible bonds include:
1. Lower interest payments
Generally, investors ask for lower interest payments on convertible bonds than on regular bonds. Thus, issuing companies can save money on their interest payments.
2. Tax advantages
Since interest payments are tax-deductible, convertible bonds will allow the issuing company to benefit from interest tax savings that are not possible in equity financing.
3. Deferral of stock dilution
If a company is not willing to dilute the shares in the short or medium term but is comfortable to do it in the long term, convertible bonds financing is more appropriate than equity financing. The current company’s shareholders will retain voting power and they may benefit from the capital appreciation of its stock price in the future.
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