Convertible Bonds

What are Convertible Bonds?

• A convertible bond is a fixed-income corporate debt security that yields interest payments, but can be converted into a predetermined number of common stock or equity shares.

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• The conversion from the bond to stock can be done at certain times during the bond's life and is usually at the discretion of the bondholder.

• A convertible bond provides the investor the option to convert the value of the outstanding bond into equity of the borrowing firm, on pre-specified terms.

• Exercising this option leads to redemption of the bond prior tomaturity, and its replacement with equity.

Features of Convertible Bonds

• Coupon Payments

  Convertible bonds are legally debt securities and do come up with coupon payments, which are ranked prior to all equity securities in a default condition. Their values, identical to all bonds are subject to the current interest rates and the credit quality of the bond issuer.

• Share Price

  The share price impacts the value of a convertible consequentially. A convertible bond with an exercise price option stands far greater than the stock’s market price which is known as a “busted convertible” and generally trades at its bond value, although the yield stands on a little higher side due to its lower credit status.

• Exchange Value

  The exchange value of a convertible bond makes the bondholder entitled to convert the par value of the bond for common shares at a particular price or conversion ratio(which signifies “4:1”).

• Reversal

  This is the opposite thing. When the bond affixed share price is enormously high, the convertible starts to trade more like equity shares. If the exercise price is much less than the market price of the equity shares, the holder of the convertible can convert into the stock at a better rate.

Types of Convertible Bonds

• Vanilla Convertible
  The vanilla convertible bond is issued with a conversion price which is the price that the underlying stock must achieve for making the conversion profitable. The issue of the convertibles is in higher prices that are much higher than the underlying stock price. If the bond is converted, the unpaid accrued interest of the investor stands forfeited. Because of this, investors usually wait until entitled to the next interest payment before converting the bond into stock.

• Embedded Options
  Convertibles have a call and put option embedded over it. A call option provides the right to the issuer to vigorously redeem the bonds before maturity for a pre-fixed price. The call date is often staggered across many years after the issue date. Call options do not appeal to investors, who need additional yield above the yields on basic convertibles or vanilla. Put options provide the investor the authority to sell the bond back to the issuer at an agreeable price. This creates a floor price on the bond which appeals to investors and thus lowers the desired yield on the bond. Many convertible bonds provide both options.

• Mandatory Convertible
  The mandatory convertible bonds are issued by the companies with a particular conversion dates. The bonds are required to be converted by the investors to the underlying stock no further than this date. These bonds often have relatively short tenures.

• Exchangeable Bonds
  The exchangeable bonds come up with a special trait where the underlying bond and the stock are from different issuers. Exchangeable bonds do possess all the other traits of convertible bonds.

• Contingent Convertibles
  These bonds must achieve a price above the conversion price before they get converted. The required price is often some fixed percentage above the conversion price, and the stock must trade at the required price for a pre-defined price before conversions are permitted.

• Foreign Currency Convertible Bond
  The denominations of these convertibles are in a currency other than the denominations used in the issuer’s country. This characteristic would make the bond more preferable, because interest payments would not be based on the exchange rate fluctuations that result in fewer dollars per thousands of rupees.