The Foundation of Convertible Bonds

The Foundation of Convertible Bonds

The Foundation of Convertible Bonds

Convertible corporate bonds, which are also known as convertible notes, refer to the corporate bonds issued by the issuer according to law and can be convertible into shares according to agreed conditions within a certain period of time. With the continuous development of the convertible bond market and the improvement of various systems, raising money using convertible notes has become an important way of financing in the capital market.

As a mixed financing tool with multiple properties, convertible bonds have unique advantages over equity financing and debt financing. 

First, the financing cost of issuing convertible bonds is relatively low. Because it can be converted into company shares under certain conditions, as the “cost”, the interest rate of convertible bonds is generally lower than that of non convertible bonds, and the interest expense of issuing convertible bonds is less than that of general bonds. 

Secondly, the issuance of convertible bonds can avoid the short-term rapid expansion of the company’s equity. Financing using it can greatly alleviate the dilution effect of traditional equity financing. Through a long period of conversion, the holders of convertible bonds can gradually convert the bonds into shares, which slows down the dilution of equity. 

Lastly, the issuance of convertible bonds can enable investors to enjoy the benefits brought by the rise of shares while obtaining the minimum return. As a kind of low-interest bond, it will still have fixed interest income even after losing the significance of conversion, which guarantees investors to obtain fixed principal and interest income.

At present, although the scale of convertible bonds is not large in China, its advantages have been recognized by quite a lot of investors, with a relatively stable investment group, and also provide investors with a variety of investment channels. When investors invest in convertible bonds, they should pay attention to the following characteristics of convertible bonds:

  1. The creditor’s rights. Creditor’s right is the basic attribute of convertible debt. The creditor’s rights of convertible bonds, like ordinary corporate bonds, refers to a kind of debt relationship formed by the companies raising funds from the public,. The issuer shall repay the principal and interest to the creditor according to the contract, which shall be included in the balance sheet of the company. Although it can be converted into shares, their nature as corporate debts has not changed before the conversion. In addition, if the investors who hold the convertible bonds do not exercise the right of conversion during the conversion period, it will remain as debt.
  2. Equity. After convertible bonds are converted into shares, the original creditors become shareholders of the company and enjoy the rights of shareholders such as dividend distribution. The hybrid nature of convertible bonds is not only reflected in the fact that they can be converted into shares of the company, but also in the “potential state” before the conversion. It is the equity characteristics that make the face value of convertible bonds be positively correlated to the stock price of the company before the conversion.
  3. Convertibility. The importance of the convertible bond lies in the fact that it gives the creditor a flexible option to convert, and whether to convert is entirely decided by the creditor himself, making the convertible bond an investment instrument that is equally good at attack and defense. If the market price of the stock is higher than the conversion price, the investor can convert the held convertible bonds into shares and obtain profits; if the market price of the stock is lower than the conversion price, the investor can choose to redeem at maturity and enjoy the fixed principal and interest interests of the original bonds.
  4. Option. Convertible bond is a kind of financial derivative instrument evolved from corporate debts with a conditional option. The options of convertible bonds include the right to lower the conversion price, the right to call in advance and the right to sell back. These contents will be introduced in a separate article.

It is these multiple attributes that determine that convertible bonds have the characteristics of both equity and debt. Investors should consider their investment preferences thoroughly and make the investment decision prudently according to their own risk tolerance.

(Disclaimer: This article is only issued for the purpose of investment education and does not constitute an investment proposal. Investors operate on this basis at their own risk. We strive to make the information in this article accurate and reliable, but does not guarantee its accuracy, integrity and timeliness, and will not be liable for the losses caused by the use of this article.)

Conversion Ratio

The conversion ratio—also called the conversion premium—determines how many shares can be converted from each bond. This can be expressed as a ratio or as the conversion price and is specified in the indenture along with other provisions.

For example, a conversion ratio of 45:1 means one bond—with a $1,000 par value—can be exchanged for 45 shares of stock. Or it may be specified at a 50% premium, meaning if the investor chooses to convert the shares, he or she will have to pay the price of the common stock at the time of issuance plus 50%.

The chart below shows the performance of a convertible bond as the stock price rises. Notice the price of the bond begins to rise as the stock price approaches the conversion price. At this point, your convertible performs similarly to a stock option. As the stock price moves up or becomes extremely volatile, so does your bond.

It is important to remember that convertible bonds closely follow the underlying share price. The exception occurs when the share price goes down substantially. In this case, at the time of the bond’s maturity, bondholders would receive no less than the par value.

The Downside of Convertible Bonds: Forced Conversion

One downside of convertible bonds is that the issuing company has the right to call the bonds. In other words, the company has the right to forcibly convert them. Forced conversion usually occurs when the price of the stock is higher than the amount it would be if the bond were redeemed. Alternatively, it may also occur at the bond’s call date.

This attribute caps the capital appreciation potential of a convertible bond. The sky isnot the limit with convertibles as it is with common stock.

For example, Twitter (TWTR) issued a convertible bond, raising $1.8 billion in September 2014. The notes were in two tranches, a five-year due in 2019 with a 0.25% interest rate, and a seven-year due in 2021 at 1%. The conversion rate is 12.8793 shares per $1,000, which at the time was about $77.64 per share. The price of the stock has ranged between $35 and $56 over the last year.

To make a profit on the conversion, one would have to see the stock more than double from the $35 to $40 range. The stock certainly could double in short order, but clearly, it’s a volatile ride. And given a low-interest rate environment, the principal protection isn’t worth as much as it might otherwise be.

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