A company issues bonds to raise capital from the public as a loan. A company can issue any bond based on its requirement. A convertible bond is one among them, which is a hybrid debt instrument that strikes a balance between equity and debt. This debt instrument allows the company to convert the bonds into equity shares. This article will discuss convertible bonds and their features, types, advantages, and disadvantages.
What are Convertible Bonds in India?
A convertible bond is a hybrid debt instrument that has the features of both equity and debt components. This bond gives the purchaser a right or an obligation to convert the bond into equity shares of the issuing company. The quantum and value of shares are predetermined at the time of issue in the offer document. Also, after converting these bonds into stocks, the bondholder becomes the shareholder of the issuing company.
An investor can convert the bond into stock only during the tenure of the bond. In other aspects, this bond is similar to a regular corporate bond. It also offers fixed tenure and periodic interest payouts at predetermined intervals. If the investors choose not to convert the bond into equity shares, they will receive the bond’s face value on maturity. Moreover, these bonds yield lower interest than corporate bonds because of their convertible feature.
Features of Convertible Bonds
The following are the features of these bonds.
- Coupon Payment: Convertible bonds are debt securities that are more secure than any other equity-based security. The coupon payments are dependent on the market interest rates. Also, the credit quality of the issuer decides the value of these bonds.
- Conversion Ratio: The number of equity shares that the holder receives in exchange for bonds is the conversion ratio. The issuer determines this ratio at the time of issue. However, this ratio does not impact the bond value. It helps to decide the total value of equity shares the owner will receive upon conversion.
- Conversion Price: It is the actual share at which the company issues and allots to the bondholder. Several factors determine the conversion price, including current book value, market price, expected appreciation in the value of equity shares, etc. The conversion price should be higher than the bond price, allowing investors to profit when these securities mature.
What are the Types of Convertible Bonds?
The company offers different types of convertible bonds to its investors. The following are the types of convertible bonds –
- Regular Convertible Bonds: Generally, companies issue these types of convertible bonds to the public. They have a fixed maturity date and a preset conversion price to equity. Also, the issuing company makes periodic interest payments to the investors until maturity. Upon maturity, the investors may choose to convert the bonds into equity shares of the issuing company at the predetermined price conversion price or redeem the bonds at their face value. Moreover, these bonds merely give a right to investors and not an obligation to convert.
- Mandatory Convertible Bonds: Unlike regular convertible bonds, these bonds obligate the investors to convert bonds into equity shares upon maturity. Also, these bonds make regular interest payments until maturity, after which the bonds are compulsorily converted into equity shares. Moreover, several companies offer higher interest rates on these bonds because they force investors to convert their bonds.
- Reverse Convertible Bonds: Upon maturity, the issuing company holds the right or obligation to convert the bonds into equity shares at a preset conversion price. However, the issuing company may convert the bonds or retain them depending on the circumstances and the share price at the time of maturity.
Who Should Invest in Convertible Bonds in India?
Investing in these bonds are suitable for investors who can wait until the maturity period to receive the proceeds. They become more attractive for investors when companies have high growth potential and low capital. Consequently, as the maturity period ends, these companies are expected to have equity share prices, making the return on investment substantial.
However, investors must have good knowledge about market conditions and trends before investing in a convertible bond. This enables them to understand the risk associated with them and convert the bonds as per their investment planning.
What are the Advantages of Investing in a Convertible Bond?
The convertible bonds are advantageous for both investors and the issuing company. The following are some of the advantages of these bonds –
Investors enjoy dual benefits while investing in a convertible bond. Apart from receiving fixed interest rate payments on their investments until maturity, holders also enjoy the benefit of stock value appreciation.
In addition, investing in convertible bonds has a low level of default risk. During the liquidation of the issuing company, the bondholders receive the first preference on the liquidation proceeds of the company. Therefore, the risk of default reduces because the investment is guaranteed to a certain extent.
For issuing company
The issuing company can raise capital quickly without diluting its equity shares, which is the case for equity financing. By issuing convertible shares, the company can postpone the share dilution for a later time.
Investors of these bonds get to participate in the share value appreciation process. Therefore, the issuing company offers a slightly lower interest rate on convertible bonds than the rate on traditional corporate bonds.