You should understand convertible bonds before investing your valuable hard earned savings in them. As compared to a regular fixed term bond, convertible bonds are different and possess some complex features. If you put little effort to concentrate on the difference, you will easily understand the significance of convertible bonds.
Regular bonds, with a face value (i.e. original purchase price), is pure debt instrument which has a fixed term of maturity and a specified coupon i.e. interest rate. Depending on the interest pay out frequency, you receive the interest amount based on coupon rate annually or semi-annually.
Along with these built-in features, convertible bonds have a new additional attribute of equity option. You might be familiar with the word “equity”, which is nothing but stock or shares of a corporation. The corporation can be large or small. It might have strong or weak financial position at the time of issuing the convertible bond. Private corporate doesn’t issue these types of bonds.
Convertible bonds hves lower coupon rates in comparison to regular debt bonds. There is very simple reason behind it. You get conversion facility with convertible bonds which might prove more beneficial and you can gain more profit than with regular bonds.
It is totally managed by you to receive the coupon amount for specific duration. After some period, if you realize that the stock price of the issuer is going up, you can convert your bond into stocks at the predetermined conversion ratio. Conversion ratio is number of shares per bond at a fixed share price.
Issuers provide the flexibility of bond to shares conversion at a future date. Conversion ratio is decided with the initial purchase of convertible bonds. The owner of the bond doesn’t have the obligation to forcefully exercise the equity option. The owner also has the flexibility to choose the equity option and execute the conversion process purely on his wish. It is most probable that bond owners will only try this option in the case of there being some profit in comparison to final maturity amount.
However, suppose the market’s condition is not good or the issuer’s stock has not performed well. The issuer stock price will continue to fall and if the owners of convertible bonds never go for the equity option; then the owner will be at the loss end. This is so because the investor never received the profit related to equity and also he has lower coupon rate in hope of converting to profitable stocks.
When convertible bonds iare converted and diluted into common stocks, you gain the rights to vote in corporation financial decisions. There are some convertible bonds that might not have this voting power as they might be converted into other type of segregated issuer stocks. Once converted into stocks, you should utilize your share trading skills and implement it to achieve maximum profit.
Convertible bonds might prove unhealthy and threat to smaller corporations. Suppose an investor owns large amount of convertible bonds of that issuer. The investor can convert the bond into shares. If the investor get large and major chunk of company’s shares, the company might loose its financial managing power and have to hand over the entire power to that investor.
Convertible bond owners can divert the flow of shares and impact existing shareholders of a corporation. When they convert the bond into shares, the company’s stock gets diluted and impacts the overall market price. There might be numerous short selling due to prior knowledge of this bond to equity conversion which might contribute in shares downfall.
Convertible bonds are preferable to those kinds of investors who have actual interest in equity sector but do not wish to face more risk. Convertible bonds have limited risk as the conversion option is exercised at the bond owner’s pace. The limited risk comes with lower bond coupon rate. So typical debt investors, who do not wish to prefer equity might find it suitable to opt for regular fixed bonds. With regular bonds, the owner doesn’t have to keep watch on the issuer’s stock price, and as an independent investor you have your own risk absorbing attitude. Hence you can decide your best flavor.