How Do Convertible Bonds Work.A convertible bond is a security whose holders receive interest payments (coupons) just like holders of ordinary bonds. However, when a convertible bond is redeemed, its issuer (the company that issued these bonds) can pay investors not the money they invested, but their shares.
Companies issue convertible bonds so that they have the option not to repay the debt with cash in case the company’s financial condition is unstable at the time of redemption.
The main indicators in terms of issuing convertible bonds are the price and the conversion ratio.The conversion price is the fixed price of a share at which it is exchanged for bonds.
The conversion rate (rate) is the number of shares (or other securities) that an investor will receive when converting one bond.These indicators are fixed and do not depend on the ratio of the market prices of the bond and the shares into which it is converted.
The conversion rate can be calculated using the following formula:
Conversion ratio = Bond face value / Conversion price
For example, you bought a bond at par for ₽1,000, and the conversion price was ₽100. Therefore, on the day of conversion, the issuer will be obliged to pay for it: 1000 / 100 = 10 shares of X. The income or loss on the bond will depend on the price of shares of X on the day of conversion.
| ?The market price of 10 X shares is above 1000 ₽ | ?The market price of 10 X shares is below 1000 ₽ |
|---|---|
| You will receive additional profit | You will receive a loss that can even cover the income from coupon payments |
The procedure, coefficient (rate) and date of conversion can be found in a special issuing document – the conditions for issuing bonds. The return on a convertible bond is not guaranteed because the market price of the asset into which the bond is converted may change.
Final Recommendatons;How Do Convertible Bonds Work
Convertible bonds are a type of corporate bond that gives the holder the option to convert the bond into a specific number of shares of the company’s common stock at a predetermined price or ratio, during a specified period. This feature provides the bondholder with the ability to participate in any potential appreciation in the company’s stock price.
Here’s how convertible bonds work:
- Issuance: A company issues a convertible bond to raise capital. The bond will have a stated coupon rate (interest rate) and a maturity date, just like a regular bond.
- Conversion: The bondholder has the right to convert the bond into a predetermined number of shares of the company’s common stock during a specified period. The conversion ratio is typically based on the current market price of the company’s common stock and is included in the bond’s terms and conditions.
- Premium: The conversion ratio may include a premium over the current market price of the company’s common stock, which compensates the bondholder for giving up the bond’s fixed interest payments for the potential upside of owning the company’s stock.
- Benefits: If the company’s stock price increases, the convertible bondholder can convert the bond into shares of the company’s stock and participate in the appreciation. If the company’s stock price falls, the bondholder can keep the bond and continue to receive the fixed interest payments.
- Redemption: If the bond is not converted into stock by the maturity date, the company must pay back the principal amount of the bond to the bondholder.
Convertible bonds offer a unique investment opportunity that combines the potential for capital appreciation with the safety of fixed income. They are typically issued by companies that have a higher risk profile, which means they have higher potential for stock price appreciation, but also a higher risk of defaulting on their debt obligations. As with any investment, it’s important to understand the risks and rewards before investing in convertible bonds.