Convertible bonds are corporate bonds that can be converted into the common stock of the issuing company at
the behest of a bondholder. However, the conversion of a convertible bond is subject to certain restrictions, depending on the
policies of the issuing authority.
Convertible bonds are issued and traded in various countries. Of these, the convertible bond markets in the US and Japan are
highly liquid and are of key importance across the globe.
How Convertible Bonds Work
Convertible bonds act like corporate bonds in the initial phase. The only distinguishing factor is the interest rate, which is
slightly lower in the case of convertible bonds. Such bonds can be converted for a specific number of common shares of the issuing
company. The number of shares that one can acquire with one bond is called the conversion ratio, which is specified at the time
of purchase. If the conversion ratio of a bond is specified as 50: 1, a bondholder will receive 50 shares for each bond held.
At times, companies can even specify a condition for conversion.
Until an investor opts to convert his/her bonds into shares, s/he can receive returns in the form of interest. S/he can receive
the complete returns on the investment after the redemption of the bonds or after selling the shares acquired through conversion.
Advantages of Convertible Bonds
Some of the benefits of convertible bonds are:
- They can be converted into equity, giving investors some flexibility.
- If the company’s share price is appreciating, investors can convert these bonds into equity and realize better returns.
- They are considered to be a safe investment as investors are assured of receiving at least the par value.
- These bonds are usually less volatile than stocks.
Drawbacks of Convertible Bonds
The drawbacks of convertible bonds are:
- These bonds yield lower returns than they would on non-convertible bonds.
- If the company’s share price fails to rise above the returns offered by the convertible bonds, an investor would not have an option to convert these bonds.
- If the company is not performing well, investors would have to settle for low returns from convertible bonds.
- The issuing company can forcefully convert convertible bonds when the price of the company’s stock is higher than the redemption cost of the bonds.
This feature can limit the price appreciation potential of these bonds.
Convertible bonds possess qualities and limitations of both stocks and bonds. Hence, only experienced investors should venture
into this investment option.