Convertible Bonds

Convertible bonds are corporate bonds that can be wholly or partly converted to a set number of shares of the bond issuing company. It offers flexibility, thereby allowing investors to either collect steady interest or convert to equity if the capital market conditions are favourable.

Like in any other bonds, the investors receive interest payments but only until the bonds are converted into equities. However, unlike regular bonds, the value of convertible bonds is driven by two components:

Depending on the terms of the issue, the bond may be converted to equities at the option of the investor, when a specified event happens or compulsorily after a certain time period. The conversion can either be at a pre-determined price set at the time of the bond issuance or at the prevailing stock price at the time of conversion.

A conversion ratio expresses the number of shares an investor can receive by converting a convertible bond. The conversion ratio of convertible bonds is dependent on the share price of the company at the time of conversion. It is usually fixed at bond issuance and calculated by dividing the convertible bond’s par value by the conversion price of shares:

Conversion Ratio = Par Value of the Bond / Conversion Price

For example, if a bond has a par value of Rs. 12,000 and a conversion price of Rs. 600, the holder will receive 20 shares (Rs. 12,000/ Rs. 600).

As a result of this potential for growth, the coupon maybe relatively lower than that offered for a similar non-convertible bond. The stock price at which the convertible bond can be exchanged for shares of common stock is called the conversion price.

Payment frequency - The payment frequency of these bonds can be monthly, quarterly, semi-annually annually or on the maturity date. These bonds can also be zero coupon.

Convertibility - These bonds automatically are or can be converted into equity shares or preference shares of the bond issuing company.

Safety: Investors should refer to the credit ratings of the bond issuing company before investing.

Collateral: Convertible bonds are usually unsecured in nature. Only a few may be backed by the assets of the issuing entity. So that in case of the bond issuing entity’s liquidation or default, the pledged assets can be used to make repayments to the bondholders.

Coupon (Interest) Rate: The coupon rates of convertible bonds can be fixed and floating. However, most convertible bonds are offered at fixed interest rates. Also, the coupon (interest) rates of convertible corporate bonds are usually lower than their non-convertible bonds.

Conversion Price: The conversion price of these bonds is set at the time of bond issuance or at the time of conversion.

Conversion Period: Specified period when the bondholder can convert their bonds into equities.

Convertible bonds are classified into compulsorily convertible bonds and optionally convertible bonds, which are further classified as fully and partly convertible bonds.

Compulsorily Convertible Bonds, also referred as Compulsorily Convertible Debentures (CCDs), are to be mandatorily and automatically converted into equities of the bond issuing company at a specific period or on a certain event.

Investors of non-convertible bonds can optionally convert these bonds into equity shares of the bond issuing company.

The advantages of holding convertible bonds from the investor’s perspective is as below:

Convertible bonds are subject to risks related to both bonds as well as stocks. Some of them are mentioned as below:

The conversion period of convertible bonds is governed by the bond’s terms often beginning after an initial lock-in phase and continuing until the bond’s maturity date. Some bonds may include triggers, such as stock price thresholds that activate the conversion option.

In case of optionally convertible bonds, the right time for conversion is when the market price of the bond issuing company’s shares is higher than the conversion price, making conversion economically beneficial. Investors may also consider converting these bonds when they expect sustained growth in the company’s fundamentals and future earnings.

In case of compulsorily convertible bonds, investors do not decide the conversion period. It is pre-specified in the bond certificate and is usually structured to occur when the company reaches a certain stage of growth or valuation, as disclosed in the offer document.