Convertible bonds are a type of fixed-income security that can be exchanged for common stock in the issuing company depending upon the bond’s conversion ratio. The conversion ratio also called the conversion premium, determines how many shares can be converted from each bond.
For example, a conversion ratio of 25:1 means one bond with a par value of $100 can be exchanged for 25 shares of the company.
They are just like regular corporate bonds, albeit with a slightly lower interest rate or coupon rate as the investors are ready to accept a lower rate due to its conversion feature.
Companies issue convertible bonds to lower the coupon rate on debt and to delay dilution. Raising capital through issuing convertible bonds rather than equity allows the issuer to delay dilution to its equity holders.
Pros and Cons of Convertible Bonds-
|Investors receive fixed-rate interest payments with the option to convert to stock and benefit from stock price appreciation. Investors get some default risk security since bondholders are paid before common stockholders. Companies benefit by raising capital without immediately diluting their shares. Companies may pay lower interest rates on their debt compared to using traditional bonds.||Due to the option to convert the bond into common stock, they offer a lower coupon rate. Issuing companies with little or no earnings, like start-ups, create an additional risk for convertible bond investors. Share dilution happens if the bonds convert to stock shares, which may depress the share’s price and EPS dynamics.|