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Why Do Companies Issue Convertible Bonds?

They tend to be more useful for companies with high risk/reward profiles. Such firms often issue convertibles to pay lower interest rates on their debt. Investors will generally accept a lower coupon rate on a convertible bond than an otherwise identical regular bond because of its conversion feature. For example, Amazon.com was able to obtain a 4.75% interest rate on convertible bonds in 1999. 3 

What happens when you convert a bond to stock?

The result is that stockholders own a smaller piece of the pie after bondholders convert their holdings. For example, Carnival Corp. (CCL) issued some zero-coupon convertible bonds back in 2003 that automatically turned into stock if Carnival's share price hit $33.77. According to the terms of the indenture, convertible bondholders would be allowed to buy the company's stock at $30.70 per share. The bonds did not offer coupons, so investors needed a sweetener. The $3.07 difference between the market price and the conversion price of the bonds provided it. Unfortunately for stockholders who didn't own them, the bonds converted to over 17 million shares. 4  That made for a highly dilutive conversion and negatively impacted existing shareholders.

What triggers a convertible bond?

Sometimes, the trigger on a convertible bond is share price performance. In those cases, the bonds convert automatically as soon as the company's stock reaches a set price. Such automatic conversions are a bone of contention among some investors and shareholder advocates.

What happens when you convert a convertible bond?

In the absence of protections, convertible bonds almost always dilute the ownership percentage of current shareholders.

When a company exercises a right to redeem or call a convertible bond, it can force the conversion of the?

When a company exercises a right to redeem or call a convertible bond, it can force the conversion of convertible bonds to stocks. The bond's prospectus will usually explain the terms of any such forced conversion call feature. 2  A company will often force a conversion when the price of the stock approaches the bond's conversion price.

Can a company convert a convertible bond to a stock?

The transformation of convertible bonds into shares of stock is usually done at the discretion of the bondholder. When a company exercises a right to redeem or call a convertible bond, it can force the conversion of convertible bonds to stocks.

Which type of bond is best for a company with weak credit ratings?

Companies with weak credit ratings that expect their earnings and share prices to grow substantially within a specific time period also tend to favor convertible bonds.

Why Do Companies Issue Convertible Bonds?

Companies issue convertible bonds or debentures for two main reasons. The first is to lower the coupon rate on debt. Investors will generally accept a lower coupon rate on a convertible bond, compared with the coupon rate on an otherwise identical regular bond, because of its conversion feature. This enables the issuer to save on interest expenses, which can be substantial in the case of a large bond issue.

How does a convertible bond perform?

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.

What is convertible bond?

Convertible bonds are corporate bonds that can be exchanged for common stock in the issuing company. Companies issue convertible bonds to lower the coupon rate on debt and to delay dilution. A bond's conversion ratio determines how many shares an investor will get for it. Companies can force conversion of the bonds if the stock price is higher ...

Why are convertible bonds better than non-convertible bonds?

Because convertibles can be changed into stock and, thus, benefit from a rise in the price of the underlying stock, companies offer lower yields on convertibles. If the stock performs poorly, there is no conversion and an investor is stuck with the bond's sub-par return—below what a non-convertible corporate bond would get. As always, there is a tradeoff between risk and return.

Why do companies offer lower yields on convertible bonds?

Because convertibles can be changed into stock and, thus, benefit from a rise in the price of the underlying stock, companies offer lower yields on convertibles. If the stock performs poorly, there is no conversion and an investor is stuck with the bond's sub-par return—below what a non-convertible corporate bond would get.

What is the downside of convertible bonds?

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.

Why do people invest in convertible bonds?

At their most basic, convertibles provide a sort of security blanket for investors wishing to participate in the growth of a particular company they're unsure of, and by investing in convertibles, you are limiting your downside risk at the expense of limiting your upside potential.

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