Understanding Convertible Bonds

Analyzing the concept of convertible bonds and the reasons why companies choose to issue them.

Understanding Convertible Bonds

Convertible bonds (convertibles) combine features of stocks and fixed-income bonds offering an investor an opportunity to convert them to a certain quantity of common shares in the issuing company. The conversion ratio is determined when the bond is issued, and the holder can act upon it at any time. Convertible bonds are similar to regular corporate bonds in the sense that they make coupon payments at the specified rate, although this interest rate is usually slightly lower than regular bonds' interest rate. The payments on convertible bonds are made until the investor decides to convert the bonds to equity.

Why Do Companies Issue Convertible Bonds? 

The reasons why companies might prefer to raise capital by issuing convertibles are two-fold.

As convertible bonds’ interest rates are typically lower than regular corporate bonds’ interest rates, the savings on interest payments can be significant. Investors would accept lower interest payments for an option to get higher returns if a stock price goes up.

Another reason has to do with preserving shareholders’ stock value. When a company raises money through a stock offering, the total number of outstanding shares increases, and the share of the existing shareholders’ equity decreases. This is called the dilution of shares. Issuing convertible bonds enables companies to raise capital without diluting the stock and reducing its value for existing shareholders. A good example is Tesla. In 2019 the company raised $2.7 billion through sales of stock and convertible bonds: a public offering of $863mm in common stock and $1.84bn in convertible notes due 2024.

Convertible bonds have obvious advantages. For example, If the company does not perform as well as expected, the bondholder will still receive the bond’s coupon payments and can utilize the option of having the bond redeemed at the maturity date. The yield of a convertible bond cannot drop down any lower than the yield of a nonconvertible bond of the same period.

Thus, convertible bonds serve as a viable middle ground for both investors and issuers. Investors get the security of receiving income when the markets are bearish, and an option of benefiting from equity appreciation when the markets are bullish, while the shareholders benefit from preserving their equity from dilution, tax savings, and more operating income before the bonds are converted to stocks.

Throughout the years convertible securities have evolved into complex structures that adjust to investors’ and issuers’ changing requirements for financing and return on investment. Stay tuned with Wolfline Capital, and in our next post, we will explain the mechanism for pricing and the formula for calculating return on convertible bonds.

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