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Convertible Bond

Definition

A convertible bond is a type of debt security that can be converted into a predetermined amount of the issuing company’s equity at certain times during its life, usually at the discretion of the bondholder. It is a hybrid security with debt and equity-like features. It is advantageous for investors due to its potential for capital appreciation upon conversion into shares.

Phonetic

The phonetic pronunciation of “Convertible Bond” would be: /kənˈvɜːrtəbl bɒnd/

Key Takeaways

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  1. Flexibility: Convertible bonds provide a level of flexibility that other financial instruments do not. Investors have the option to convert their bonds into shares of stock if the company does well, potentially realizing greater returns.
  2. Lower Interest Rates: Because of the conversion feature, companies ordinarily pay lower interest rates on convertible bonds than they would on traditional bonds.
  3. Risk Mitigation: Convertible bonds also provide a degree of risk mitigation. If the company doesn’t do well, investors still receive interest payments and can get their initial investment back at maturity, like a traditional bond.

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Importance

Convertible bonds are important in business or finance because they offer a unique way for companies to raise capital. These financial instruments are a type of bond that allows the bondholder the right to convert the bonds into shares of the company’s common stock. This is potentially beneficial for the bondholder if the company’s stock price increases appreciably. For companies, convertible bonds could mean lower interest payments as they typically offer lower interest rates than regular bonds, due to their convertibility feature. Additionally, if the bonds get converted into shares, the company benefits by not having to repay the principal amount. In a strategic financial planning context, convertible bonds are a great way to optimize capital structure and manage financial risk.

Explanation

The purpose of a convertible bond is generally twofold: first, it offers investors the right to convert their bonds into a predetermined number of the issuer’s company shares. This option adds an equity investment upside to the bond, which is particularly attractive to investors in a rising stock market. The investor has the potential to gain from a company’s growth as they can benefit from the company’s increasing stock value. The function of a convertible bond is also advantageous to companies as these instruments can help reduce borrowing costs. Convertible bonds typically carry a lower interest rate compared with non-convertible debt due to the potential equity upside. By issuing convertible bonds, companies can attract a wider range of investors with a potentially lower cost of capital. Plus, if the bond is converted into stocks, the company does not need to pay back the principal on the bond, which can be a benefit in terms of cash management.

Examples

1. Tesla Convertible Bonds: In February 2014, Tesla Motors issued $2 billion in convertible bonds to fund its production for the Model 3 line. The bond had a conversion price significantly higher than the market price of the Tesla’s stock at the time of issue, suggesting a strong expectation of price appreciation. 2. Salesforce Convertible Debentures: In 2013, Salesforce issued convertible senior notes totaling $1.15 billion. The software company had the option to convert all or portions of the debentures into cash, shares of common stock, or a combination thereof anytime after 2018.3. Alibaba Convertible Bonds: In late 2020, Alibaba issued its first US dollar-denominated unsecured convertible bond, which offered investors fixed income interest payments until converted into shares. The convertible bonds were issued with a conversion premium of 37.5% above the reference share price, reflecting strong optimism for the company’s potential growth.

Frequently Asked Questions(FAQ)

What is a Convertible Bond?

A convertible bond is a type of fixed-income instrument that can be converted into a fixed number of a company’s share at the wish of the bondholder.

How does a Convertible Bond work?

Owners of a convertible bond may choose to trade it for a certain number of company’s shares instead of redeeming them for cash. This is usually done when the investor believes the company’s future performance will result in the shares being worth more than the bond.

Why might a company issue Convertible Bonds?

Companies might issue convertible bonds to lower the interest rate they pay. Potential shareholders can be attracted with the bond’s more conservative features removing fear of capital loss, while still offering a way to partake in the company’s future success.

What are the risks involved in investing in Convertible Bonds?

If the company’s share price doesn’t go up as expected, then the investor stands to lose potential interest income. Also, if the company fails to perform or defaults on its payment obligation, the investor may lose their initial investment.

Are Convertible Bonds considered debt or equity?

Convertible bonds are a hybrid form of investment, carrying properties of both debt and equity. Initially, they are considered as debt as they offer fixed interest payments to investors, but they can convert into equity if the conditions favour the conversion.

What benefits do Convertible Bonds offer to an investor?

Convertible bonds can provide investors the opportunity to gain from an increase in the company’s stock price while still being secure with fixed income payments. They combine the yield of bonds with the potential for equity upside.

When is the best time to convert the bond into stock?

Ideally, an investor might choose to convert their bond into shares when the company’s stock price rises, meaning the value of the shares they would receive upon conversion is more than the payoff from keeping the bond until maturity.

Can the issuer company force conversion of the bonds?

Yes, some convertible bonds have a forced conversion provision, allowing the issuer to force bondholders to convert their bonds into stocks once the stock price reaches a certain level.

Related Finance Terms

  • Convertible Premium
  • Callable Convertible Bond
  • Conversion Ratio
  • Forced Conversion
  • Conversion Price

Sources for More Information

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