In between the two worlds of debt and equity lies a middle ground of convertible bonds. If you like the stability of bonds but feel the urge of stocks, then you belong to this middle ground. This is one place where you can discover how to enjoy your first candy before asking for the second. But before you start dreaming about a river full of convertible bonds, it would be better to get into the basics.
Johnny: I have heard about a river full of candy, honey and what not. But for the first time I have heard someone talking about a river full of convertible bonds. It would be better, Jinny, if you could first explain what exactly convertible bonds are.
Jinny: Convertible bonds, or what are also called convertible debentures, are a type of debt instrument that pay you interest, like any other debt instrument. However, convertible bonds have one important feature that makes them different from ordinary bonds: They provide an option to the bondholders to get the principal amount of their bond converted into stocks of the company at a predetermined price or conversion rate after a specified period or on the maturity of the bond.
Illustration: Jayachandran / Mint
Say, for instance, that a convertible bond of company A may give an option of conversion of the principal of Rs100 into 10 common stocks at a price of Rs10 for each stock on maturity of the bond. Here, you should keep in mind that conversion of the principal of the bond into stocks is purely at the discretion of the bondholder. If the bondholder chooses to exercise this option on maturity, then in the present example he would get 10 stocks of company A as repayment of the principal. In case he decides not to exercise this option, then the principal would have to be paid in cash by the bond-issuing company, just like any other debt instrument.
Johnny: Take cash or take stocks. The choice seems to be really tough. How do bondholders decide?
Jinny: That’s not a problem. Conversion, as I said, takes place at a predetermined conversion rate. Investors choose the option of conversion only when the stock is trading at a higher price than the predetermined conversion price. If the stock is currently trading at Rs20 and the predetermined conversion price is only Rs10, then it makes sense to opt for conversion. If the current price is lower, then the bondholders would be happy to get paid in cash.
Johnny: It sounds like win-win for bondholders. But why do companies issue convertible bonds?
Jinny: You need to take a closer look at the convertible bonds to decide who wins or who loses. The structure of a convertible bond is like that of a debt instrument with the embedded option of buying the stocks of the company. In other words, you can say that the investor of a convertible bond is not just buying the bond of the company but also a stock option of the company.
Nothing comes for free. To buy this option, the bondholder has to pay a price in terms of lower coupon rate on his investment in convertible bonds.
The convertible bonds pay less interest rates than other bonds of the same company, which means that the difference in the interest rates is the price convertible bondholders pay for enjoying the stock option. The benefits of buying such an option accrues only when you finally exercise it, otherwise you just end up paying the price without ever laying your hands on the candy.
Johnny: So, investors need to think of all the pros and cons before making an investment in convertible bonds.
Jinny: Yes, that’s true. But all in all, this is a fair game for both sides. Investors of convertible bonds get a chance to take part in the future growth potential of the company while enjoying the safety of their capital. On the other hand, companies are able to raise money at a lower cost by issuing convertible bonds. This method of financing also helps companies in several other ways. In case the company decides to raise money by issuing shares, the earning per share (EPS) of the existing shareholders gets diluted straightaway, the shareholding pattern along with voting rights may also get disturbed but the financing through convertible bonds helps delay these situations. There will be an impact on EPS or voting rights only when the convertible bondholders opt for conversion in the future. Till that time, convertible bondholders receive only limited income as interest payment regardless of the profitability of the company and the major portion of the company’s income remains with the shareholders. If the company continues to do well in the future, bondholders and shareholders can together enjoy the good times.
Johnny: It’s really nice to see both sides stand on the same ground, side by side.
What: Convertible bonds provide an option of converting the outstanding principal into stocks.
Why: Companies prefer to issue convertible bonds because of their lower coupon rates.
How: Convertible bonds can be converted into stocks after certain period at a predetermined conversion rate.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at email@example.com