What are Convertible Bonds – Understanding the Concept
A convertible bond is a bond that is issued by a corporation, with the investment secured by the assets of the company. In the scenario when there is a minor or major default with investments, the holders of the bonds enjoy a legal claim over the assets of the company. Hence, the holders of the convertible bonds enjoy the right (but not an obligation) to exchange the bonds for a certain number of shares held by the company. The numbers of shares that can be exchanged is predetermined at the time of issuing the bonds, and depend on the values of the bonds.
Hence, in a scenario where the value of the stocks held by the company rises significantly, the bond holders can exchange the bonds into the shares, and make loads of money by selling the shares at the increased prices. Under these circumstances, such bondholders gain to make more money than a person with any other forms of bonds. On the other hand, if the value of the stocks remains the same or even declines, the bondholder can retain their bonds and will be eligible for the principal payment amounts as well as the predetermined interests. Hence, they will not lose money like a conventional stock holder does when the stock process fall.
Advantages of Convertible Bonds
These bonds are an attractive option for investors as they often provide a win-win situation for them. Regardless of the outcome at the end of the maturity in terms of the prices of the stocks, an investor is most likely to earn a profit on their investment. This profit may be small or big, but there are maximum chances of the investors earning this profit. In worst case scenarios, where earning a profit may not be possible, the chances of losing money on the investment is very less.
In case the shares of the company are doing well in the stock market at the time of maturity, investors can convert their bonds to shares and obtain high dividends on their investments. The conversion of the bonds will facilitate the purchase of a specified number of stocks or equity shares predetermined at the time of purchase of the bonds. Conversely, if the shares of the company are not doing well in the stock market, the holder of the bond has the option of earning the interest amounts as well as the principal amounts when the bond matures. The profits may be more when the stock prices rise, but the investors have the option of cashing in on the bonds according to their desires.
Potential risks accompanying convertible bonds
Essentially, investments are rarely free from risks, and the same can also be said for a Convertible Bond, as it also accompanies a few minor risks and disadvantages. One of the major disadvantages that such bonds have to offer is the fact that the rates of interests offered on such bonds are often lower than conventional bonds. This is a price that bondholder must pay for the unlimited upsides and options on offer due to the convertibility feature.
Additionally, such bonds can often be more complex and complicated than conventional bonds. This mostly due to the fact that a number of variables and possibilities have to be taken into account when deciding the prices and values of the many aspects included in the bonds. Hence, if a bondholder is not properly aware of all the pricing, and do not accurately comprehend the math involved, it is possible that they may end up paying more money than they absolutely need to.
Furthermore, it is important to understand that such bonds are connected directly to the stock market as well as the bond market. This allows the bonds to be cushioned by at least one market, if not both. However, if both markets suffer drops and losses, the bonds would stand to lose too. This is due to the fact that the impact of the both those market drops would be felt on the bond.
Why should one make an investment on one such bond?
Due to the large number of potential options of profits that it offers, a Convertible Bond can definitely be more profitable than any other forms or types of bonds. Investors can also enjoy a cushion from either of the bond market or the stock market in case the other drops. This cushion is not always enjoyed by other bonds. This allows such bonds to enjoy more appeal among investors than the others.