Digitisation of the financial markets has opened up a plethora of investing opportunities to the masses. It is no longer an exclusive domain, accessible by institutional investors and other major market players. Regular investors can participate just as equally through instruments like mutual funds via different online platforms.
However, participation does not equate to knowledge. The financial market can be a daunting topic for many, with a range of securities to understand for a fully comprehensive grasp. For entry-level investors, a convertible bond can be one such security that may require more understanding.
In this article
What is a Convertible Bond?
In the financial world, there broadly exist two kinds of securities – namely, equities and fixed-income instruments. But, there are hybrids as well. When it comes to convertible bonds meaning, it can be best described as hybrid security, comprising the features of both equity and debt, but not at the same time.
A convertible bond, as the name may suggest, is a fixed-income security option that the holder can convert into common stocks at a later date. As long as it is in effect as a bond, i.e. a fixed-income instrument, the investor will continue to earn interests periodically.
Upon conversion, it will take on the features of equity, whereupon the investor will become a shareholder and enjoy the rights and benefits that come with it. Typically, the investor can effectuate such conversion at their volition. In this context, the conversion ratio and price are two essential concepts.
What is Conversion Ratio?
It is a ratio determining how many stocks an investor can avail against one unit of such a bond. For instance, if a convertible debenture features a ratio of 10:1, it signifies that an investor can receive 10 common stocks against one unit of such debenture.
This ratio influences the conversion price of a bond. It is the rate at which a debenture or preferred share can be converted into common stock. For example, suppose the par value of a debenture is Rs.1000, and it features a conversion ratio of 5. Here, the conversion price will be Rs.200, i.e. 1000/5.
What are the Different Types of Convertible Bonds?
A company can issue three types of convertible bonds, primarily. These are –
- Vanilla convertible bonds
It is the most standard type of a convertible bond. Here, the discretion of whether to convert it to common stock or hold them as a fixed-income instrument until maturity lies entirely with a bondholder.
Usually, if prices of underlying stocks dip over time, bondholders prefer to hold them until maturity and then receive the face value of their investment. On the other hand, if such stock prices go up during the course of maturity, individuals cash in their option to convert in order to capitalise on value growth.
- Mandatory convertible bonds
Holders of mandatory convertible bonds do not enjoy the choice like with its vanilla counterpart. This type comes with a predetermined date when issued. In this case, a bond will automatically convert into an equivalent number of common stocks per conversion rate on such predetermined date.
Up to the contractual date, investors will continue to receive periodic interests as with any other fixed-income instrument. Usually, the only choice that holders possess in this regard is opting to convert their holdings into common shares prior to such preset date.
- Reversible convertible bonds
Here, the discretion lies with the issuer. The company in question can provide a fixed number of shares to investors or redeem them by disbursing cash on the maturity date. One shall note that, in this case, the conversion is done at a predetermined rate and ratio.
When is the Right Time to Convert?
In case of vanilla convertible bonds, investors might grapple with when to opt for conversion. While there’s no right time for that, the primary criterion is that the price of such underlying stock should demonstrate an upward trend.
However, it does not end there. An investor should also consider whether the increase in price trumps the face value of such bonds plus the interest they are eligible to earn. If it does, then conversion is ideal.
A convertible bond example would clarify this further. The following table shows the hypothetical details of convertible bond issuance by Company ABC.
|Face value of a convertible bond||Rs.10,000|
|Maturity period||5 years|
Therefore, the conversion price is Rs.1000. Every year, an investor receives Rs.600 as interest against one unit. It holds onto the bonds for 3 years. At that point, ABC stocks are trading at Rs. 1100.
Here, if the investor decides to convert, she will receive 10 stocks worth Rs.1100. If she sells them immediately, she can earn Rs.11000, which outdoes Rs. 10,600 (10000 + 600).
Alternatively, if such stocks traded at Rs.900, she would have suffered a loss of Rs.1600.
A convertible bond is time-sensitive. Thus, it is essential to understand when to sell for maximising profits.
What are the Advantages of a Convertible Bond?
Convertible security provides the following benefits to investors and issuers –
- Investors receive interests periodically while having a finger on the vein of a stock price increase.
- Bondholders can capitalise on price appreciation without assuming much of the risk of fall in value.
- If a company is liquidated, bondholders are paid their dues prior to stockholders.
- Companies can issue convertible bonds at lower coupon rates than regular debentures or preference shares.
- Companies do not need to dilute ownership when issuing this instrument.
What are the Downsides of a Convertible Bond?
Investors and issuers can face the following disadvantages with this hybrid security –
- Since investors enjoy the option of conversion, the interest they earn is lower than regular fixed-income securities.
- If bondholders decide to cash in their option of conversion, it will dilute the ownership stakes of the issuing company. That might not bode well with shareholders, leading to a fall in share prices and EPS.
Nevertheless, individuals can invest in convertible bonds via mutual funds and ETF. Such funds usually track market volatility closely. Thus, it can introduce some diversification and also a potential for substantial income into portfolios primarily dominated by traditional fixed-income instruments.