What Are Convertible Bonds

Introduction

There are different types of Bonds available in the market. Convertible Bonds, which corporate firms issue, are one among them. This Bond is convertible, which means the Bond owner can convert it to shares of the company's stock. When you convert the bonds into shares, you enjoy the same rights as a shareholder. The Bonds generally offer higher yields than stock but lower yields than Corporate Bonds.

How do they work?

Since you are aware of what are Convertible Bonds, let us see how they work. Corporate firms issue Bonds when they need funds, and through the issue, they raise money for the business. Let us assume a company issues a five-year Convertible Bond with a par value of Rs. 1,000 and a coupon of 5%. If the investor exercises the conversion at a 25:1 ratio, the number of shares the investor receives is 25, and the conversion price is Rs. 40 per share (Rs. 1,000/25)

The investor holds the Bonds for three years and receives Rs. 50 as interest each year, but the stock goes over the conversation price and trades at Rs.75. Now, the investor plans to convert the Bonds. He receives 25 shares valued at Rs. 1,875 (25x Rs 75). By converting the Bond, the investor gets a chance to generate income and make the most of the stock's upside.

Let us consider the opposite situation. In this case, the company's stock falls to Rs.30 per share. The investor does not convert in such an event because the stock price is lower than the conversion price. Instead, the investor chooses to hold the Bonds until maturity and receives interest income throughout the tenure.

Types of Convertible Bonds

Convertible Bonds can be classified into the following three types based on conversion features and the party holding the right to do so.

Regular Convertible Bonds

Regular Convertible Bonds are the simplest type of bond you can invest in. They are widely offered by almost all leading companies. You continue to earn interest until the bond matures. On maturity, you have the right to decide whether you want to convert the bond to an equity holding or redeem the bond at face value. Note, you hold the right and are not obligated to do so.

Consider your financial requirement and risk appetite to make a suitable choice. If you are an investor with a low-risk appetite, refrain from converting your bond to an equity holding. If your goal is to make attractive market-adjusted returns in the long run, you can opt for Equity conversion.

Mandatory Convertible Bonds

Mandatory Convertible Bonds work like any other Convertible Bond. The bond continues to reap fair interest payments until it matures. Once the bond matures, they automatically get converted into the equivalent number of equity shares according to the conversion rate on the predetermined date. Some companies tend to offer a higher interest rate on these bonds as they are certain that the investors will become shareholders on conversion.

Careful consideration is necessary when choosing to invest in a company’s bond. Understand the company’s current positioning in the market and get to know its growth potential.

Reverse Convertible Bonds

Reverse Convertible Bonds work similarly to Regular Convertible Bonds. The bonds earn you reasonable interest until their maturity. As the bond matures, the company will have the right on whether to convert the bond into an equity holding or not. The company considers the overall market standing and their positioning to make this decision. You as an investor do not have any say in the conversion decision. The conversion will take place at a predetermined rate and ratio.

Pros and cons

All investment instruments have their advantages and drawbacks. You need to keep them in mind while making an investment decision.

Pros

Regular income

Convertible Bonds pay regular income to investors. It is an ideal investment option for those looking to generate passive income.

Low risk

Bonds are considered a low-risk investment because you usually do not lose your money when you invest in them. If the company remains solvent, you receive the money on the maturity date. There is a minimal downside compared to stocks.

Cons

No value rise

Unlike stocks, Bonds do not have the potential to rise in price if the company performs well or generates strong financial results. The Bond value remains the same throughout the tenure, and even if the stock performs well, the Bonds do not rise. But there is an upside, too; if the stock does poorly, it does not affect the Bond.

Conclusion 

Convertible Bonds have a higher chance of appreciation than Corporate Bonds, but they may also be vulnerable if the issuer defaults. Precisely why you must consider the pros and cons and conduct extensive research before investing in Bonds.