What Are Convertible Bonds
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.
Pros and cons
All investment instruments have their advantages and drawbacks. You need to keep them in mind while making an investment decision.
Convertible Bonds pay regular income to investors. It is an ideal investment option for those looking to generate passive income.
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.
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.
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.
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