A convertible bond is a type of debt instrument which also has equity-like features. It can be converted into the shares of the issuing company at a later date and at a pre-determined conversion price. It can also be classified as a derivative instrument because it derives its value from both the prevailing interest rates and the stock price of the company. Convertible bonds are usually issued by those companies which have a lower credit rating. Because of the lower rating, they would need to pay a high coupon rate and a high yield to attract investors to their bonds. So instead of issuing plain bonds, they issue convertible bonds. Convertible bonds have a lower yield than the plain bonds, but provide additional upside to the investors through conversion to equity. If the investors are not able to convert their bonds, they will anyways be entitled to the regular coupon payments, albeit at a rate lower than the market. It is a win-win for both the issuer and the investor. Convertible bonds are also termed as just ‘convertibles’ or ‘converts’.
Convertible Bond Characteristics: A convertible bond can be described by the following characteristics:
- Conversion Price: The pre-determined share price at which a convertible bond can be converted into the shares of the company. The conversion price is usually at a high premium to the prevailing market price when the bonds are issued.
- Conversion Ratio: The number of shares that an investor gets after converting one bond. A conversion ratio of 100:1 will mean that the investor will get 100 shares for each convertible bond that he holds.
- Conversion Date: Convertibles can be designed to have certain periodic conversion dates or windows in which these can be converted into the shares of the issuing company.
- Issuance Premium: The mark-up of the conversion price over the current market price at the time of issuing the convertible bonds. This is usually high to push the dilutive effects of the bonds in future.
- Coupon: The periodic coupon payments to the investors. The coupon rate is fixed at the time of issuance.
- Yield: Yield of the convertible bond at the time of issuance.
- Maturity: Like a normal bond, a convertible bond also has a maturity. It is the time when the investors get the principal value of the bond back and the debt expires.
- Option like Characteristics: Convertibles can also be designed to have an option like features. The issuing company can have a right to call the bonds before the conversion date or maturity. Similarly, the investor can have a put option where he can redeem the bond and get full principal before maturity if the stock price goes below the conversion price.
Convertible Bond Types: Convertible bonds can be classified based on the variation in their underlying characteristics
- Plain Vanilla Convertible: It is the simplest form of convertible which has fixed conversion price and maturity. If the stock price reaches the conversion price before the maturity, the investor can convert the bond to stocks. But the investor will have to forego any accrued interest between the last and the next coupon payment if he converts between two consecutive coupon dates. The investor can choose to convert or not to convert based on the stock price.
- Mandatory Convertible: It has to be converted irrespective of at what price the share is currently trading.
- Embedded Option Convertible: As explained in the characteristics of convertible bonds, these can be issued with a call option to the debt issuer or a put option to the bond investor.
- Original Issue Discount Convertible: These are issued at zero coupons and a heavy discount to the par value of the bond. Naturally, they have a high yield and are issued by companies which are facing or expected to face a cash crunch.
- Exchangeable Convertible: The bond can be converted into the shares of a different company or a different instrument altogether.
- Contingent Convertible: The conversion is contingent upon the stock price reaching a certain mark-up over the conversion price and remaining there for a certain period of time.
- Convertible Preferred: The originally issued instrument is a preference share instead of a bond. The features are similar to a convertible bond. The yield is higher than a convertible bond.
- Foreign Currency Convertible Bond (FCCB): If a company wants to raise money from a foreign country, it will issue FCCBs. FCCBs are denoted at a currency which is different from the currency in which the issuer does its business. These are prevalent amongst the companies from developing nations like India where they issue USD, GBP and EUR denominated FCCBs.