Convertible bonds are securities that have a life time of around 25 and 30 years. Convertible bonds give the owners of the bonds a right to get the common stock from the issuer of the stock and need not go to the open market to get it directly from there. The bond indenture can explain the terms and conditions to do this exchange. There is an optional feature about this bonds which will permit the bond holder to make a transition between debts and equity. Then the bond holder will be receiving lower yields as compared to the securities of non-convertible bonds.
Convertible bonds are divided into subordinated debt and unsubordinated debt. The convertible bonds falling under subordinated debt is higher in terms of risk than an unsubordinated debt. There are several features that make convertible bonds different from a normal bond. This includes their special features and structure. They have a conversion price. This price is paid on a share basis to get the common stock from the issuer. The conversion ratios is used to measure the ratio of the number of shares received by the bond holder expressed in terms of the bonds he exchanged. The Par value of convertible security divided by Conversion value will give the conversion ratio. Conversion parity will occur when a profit or loss is made during conversion. Conversion premium is another aspect that makes convertible bond special from normal bond. This differentiates the price in conversion and a normal price in market.
Issuers are highly benefited from the convertible bonds. They can save 2% as an average rate when they issue convertible bonds to their bond holders. This will be highly useful for a firm in its initial phase. Issuers can avoid the status of a dilution of shares when they issue convertible bonds. This will permit them to issue higher rate of stocks for the shareholders. Those companies which have low revenues in their pocket will be highly benefited with this.
The most added advantage of convertible bonds is that they can easily offer investors yields without any risk. With this lower yield, they can get the benefits of a higher stock price. The premium of a convertible bond will be equal to the stock value. If the conversion happens in a short period of time, the stock price will increase greatly and at this time, convertible loans will prove to be a little disadvantageous. At these particular cases, bond holders will not convert it as expected by the issuer.
Features of Convertible Bonds
Convertible bonds have a coupon payment and are legally debt securities, which rank prior to all equity securities in a default situation. Their value, like all bonds, depends on the level of prevailing interest rates and the credit quality of the issuer.
The exchange feature of a convertible bond gives the right for the holder to convert the par amount of the bond for common shares at a specified price or “conversion ratio this conversion ratio would be said to be “4:1″ or “four to one.”
The share price affects the value of a convertible substantially. A convertible bond with an “exercise price” far higher than the market price of the stock is called a “busted convertible” and generally trades at its bond value, although the yield is usually a little higher due to its lower or “subordinate” credit status.
Think of the opposite. When the share price attached to the bond is sufficiently high or “in the money,” the convertible begins to trade more like equity. If the exercise price is much lower than the market price of the common shares, the holder of the convertible can convert into the stock at an attractive rate.
Advantages of Convertible Bonds
Convertible bonds offer the investor a fixed rate of interest in the beginning years of investment. Most small investors are interested in a fixed income and would not worry about the corporate image or growth in which they make an investment. A new company offering convertible bonds is of great advantage to such investors.
They are assured of a fixed income as well as ownership rights at a later date. The expectation of an investor or is that a company stabilizes itself after some years of active working. At such a time, he would be able to get ownership rights and gain a profit also.
A convertible bond is often issued by a firm when its capital structure does not permit extensive expansion through further issue of equities or taking loans from the market at a higher rate of interest, a firm makes an attempt to balance its capital structure as well as expand its business without delay.
If expansion cannot be postponed and a large amount is required to finance such an expansion, the best measure to a company is to consider an issue of convertible security.
Sometimes, convertible bonds may be used to provide funds during the gestation period. Also, the floatation costs of convertible securities are lower than equity issue as cost of underwriting is much lower. The cost of issue to the firm during the period of gestation or expansion will be lower when convertible bonds are issued.
3. Depressed Capital Market
A capital market is very sensitive to conditions in the economy. Political instability, riots, war, economic conditions depress the capital market. Equity issues do not evoke responses from the general public as the value of shares in such conditions is very low.
Convertible bonds may be considered to be quite attractive in these conditions as to provide the twin objective of fixed income and option for transfer at a later date. Public response to these issues helps to bring some activity in a dull capital market.
Disadvantages of Convertible Bonds
A convertible bond has a particular disadvantage. So long as these bonds are bought at a reasonable price, keeping them on one’s portfolio has all the advantages outlined above. If these bonds are bought at a very high price the return is sometimes evaluated as negative.
Also, there is an excessive danger of loss if the price of the bond falls due to market risk or fall in the earnings. Another disadvantage of convertible bond is the discretion of a company to call bonds. Bondholders may at the will of the issuing company be forced to return their bonds at a small profit.
Convertible bonds also have less security than other bonds. Because they are convertible and these are treated as securities of less value than non-convertible bonds and are evaluated like equity shares. In India, debentures both convertible and non-convertible have been popular since the years 1983-84.
Types of Convertible Bonds
The basic or vanilla convertible bond is issued with a conversion price the price that the underlying stock must attain to make the conversion profitable. Convertibles are normally issued with conversion prices that are substantially higher than the underlying stock price. If the bond is converted, the investor’s unpaid accrued interest is forfeited. For this reason, investors often wait until qualifying for the next interest payment before converting the bond to stock.
Convertibles can be embedded with a put option, a call option, or both. A call option gives the issuer the right to forcibly redeem the bonds before maturity for a preset price. The call date is usually staggered several years after the issue date. Call options are not attractive to investors, who require extra yield above the yields on vanilla or basic convertibles. Put options give the investor the right to sell the bond back to the issuer for an agreed-on price. This creates a floor price under the bond, is attractive to investors and thus lowers the required yield on the bond. Many convertible bonds offer both options.
Companies issue mandatory convertible bonds with specified conversion dates. Investors must convert their bonds to the underlying stock no later than this date. These bonds usually have relatively short durations.
The special feature of an exchangeable bond is that the underlying stock and the bond are from different issuers. Exchangeable bonds can have all the other features of convertible bonds.
These bonds must attain a price above the conversion price before they can be converted. The required price is usually some fixed percentage above the conversion price, and the stock must trade at the required price for a specified period before conversions are allowed.
Foreign Currency Convertible Bond
These convertibles are denominated in a currency other than the one used in the issuer’s country. This feature would make the bond more attractive, because interest payments would not be subject to fluctuations in the exchange rate that result in fewer dollars per pound.
Evaluation of Convertible Bonds
The factors involved in evaluating convertible bonds are:
- Quality of Issue
- The current price of convertible bond
- The expected future appreciation of the equity (return and risk)
- Tax benefits
Analysis of Convertible Bonds
- Convertible bonds should be purchased during gestation periods of firms when bonds are less risky than equity stock. The investor gets a high rate of return initially and on stability of the firm, becomes its equity shareholder.
- Convertibility clauses in debentures make it an attractive purchase in unstable conditions in an economy. Debentures have been very popular in the Indian capital market since 1984.