Convertible bonds give investors the option to exchange the bond for a pre-fixed number of shares of a company. These bonds are issued similar to a plain-vanilla bond, usually with a lower coupon. This helps to lower the financing costs of companies who wish to borrow money.
How Does a Convertible Bond Work?
Company ABC’s stock is currently trading at $15 per share. Assuming Company ABC decides to issuea 5 years convertible bond with a 2% coupon and a conversion ratio of 50.
Conversion ratio is the number of common stock for which a convertible bond can be exchanged for. It also means the number of shares the bond holder receives from conversion for each bond.
Hence, the conversion price would be $20 per share ($1000 (par value of bond) divided by 50). An investor decides to buy the bond at par.
If the share price increased to $30 per share, bond holders can convert their bond into shares and receive $30 X 50 = $1500, earning a profit of $500 (a 50% return).
If the bond holder chose to buy the shares at $15 instead, it would earn her a 2x return instead!
Convertible bonds limit the downside risks for investors if they wish to participate in the growth of a company. However, the cost of a downside protection limits the upside potential due to the conversion premium (i.e. the conversion price – market price of the stock) of the bond.
Referring to the above example, if the stock ABC declined below $10 per share, the investor can continue to collect the 2% coupon from the convertible bond and wait for her principal to be returned at maturity as opposed to an investor who now has to suffer a capital loss of $5 per share.
Value in Action
Companies tend to issue convertible bonds to lower their cost of debt financing. Issuance tend to take place when the stock price is at its peak. Investors can take advantage of convertible bonds if they wish to participate in the growth of a company yet want to cap the downside risks of the stock.
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All views and opinions articulated in the article were expressed in Willie’s personal capacity and do not in any way represent those of his employer and other related entities. Willie does not own any shares in the companies mentioned above