Understanding Convertible Bonds in Stock Market

3.1 Introduction

To raise capital, companies may issue convertible bonds. A convertible bond is a bond issued by a company that offers the bondholder the right to convert the bond into a pre-specified number of common shares. Although a convertible bond is actually a debt security prior to conversion, the fact that it can be converted to common shares makes its value somewhat dependant on the price of common shares. Thus, convertible bonds are known as hybrid securities. Hybrid securities have features of and relationships with both equity and debt securities.

The number of common shares that the bondholder will receive from converting the bond is known as the conversion ratio. The conversion ratio may be constant for the security's life, or it may change over time. The conversion value (or parity value) of a convertible bond is the value of the bond if it is converted to common shares. The conversion value is equal to the conversion ratio times the share price. At conversion, the bonds are retired (cease to exist) and common shares are issued.

Because the conversion feature is a benefit to the bondholder, a convertible bond typically offers the bondholder a lower fixed annual coupon rate than that of a comparable bond without a conversion feature (a straight bond). Convertible bonds have a maturity date. If the bonds are not converted to common stock prior to maturity, they will be paid off like any other bond and retired at the maturity date

3.2 Details on conversion privilege

The conversion privilege entitles the owner of the convertible to exchange the bond into a specified number of common shares of the issuer at any time. For example, let's look at the following (fictitious) bond:

5% Nestle India 2000- 30^th June 2021 (par Value of Rs.5000) convertible into 10 shares of Nestle India.

By issuing a convertible, a company takes on debt capital that will be fully or partially converted into share capital (depending on the stock market trend) during the convertible's lifetime. The issue of a convertible is thus equivalent to a share capital increase that is spread over an extended time period. In particular, the capital raised in this way does not have to be repaid, which is often why issuers choose this method of financing. The equity into which a convertible bond can be exchanged is known as the underlying security (or simply the underlying). In the case of the (fictitious) convertible bond above, the underlying security would be Nestlé India shares.

The conversion privilege is contractually stipulated and normally applies during the entire lifetime of the bond. Of course, the specific conditions and conversion privileges are different for each bond. But the general principle (i.e. the right of conversion into equities) remains unchanged.

At the same time, there is no obligation to convert. The owner of the bond decides if and when he wants to convert. A conversion is generally only interesting if the corresponding shares have risen sharply and thus exceed the par value of the bond. In such instance, a capital gain could be achieved by converting to the shares and selling them immediately on the stock exchange.

In the case of falling equity prices on the other hand, if the owner keeps the bond, he will continue to receive interest payments and also get his invested capital back when the bond matures. Hence, the decisive advantages of convertibles are already apparent: They offer the opportunity to participate in appreciation of the underlying equity while simultaneously providing capital protection.

3.3 Let's understand the profit potential in the above example

5% Nestle 2000 - 30 June 2008 (par value of Rs. 5000) convertible into 10 registered shares of Nestle (= underlying security)

We assume that the bond was bought at 100% and thus cost Rs. 5000. Through conversion, the owner would receive 10 registered shares of Nestle. Hence, as long as the underlying security (Nestle registered shares) is trading at less Rs 500 on the stock exchange, conversion is unattractive.

But if the stock is selling at Rs. 580, for example, there is a profit:

Rs.5800 = 10 x 580 = value of shares received - 5000 = purchase price of bond

Rs.800 = profit from conversion

The converted shares can be sold immediately on the stock exchange, thus locking in the profit. Furthermore, it becomes clear that the price of the convertible can be strongly influenced by the performance of the underlying equity.

Indeed, in the example discussed here, it is immediately obvious that given a share price of Rs.580 the convertible bond is no longer available on the stock exchange at the original price of 100% (Rs. 5000), but rather must cost at least Rs. 5800 (= 116% of the par value).

If the bond were cheaper, investors could buy it, convert immediately and achieve a risk-free profit. This means that in this example, owners of the bond would not sell below 116% since such action would amount to giving money away to the new buyer. The bond must therefore trade at no less than 116%. The relationship between the number of shares each bond is convertible into (10 shares in our example) and the par value of the bond (Rs. 5000 in our example) yields the so called conversion price = 5000 / 10 = Rs. 500

The conversion price thus corresponds to the "exchange price" of the shares and remains fixed during the entire lifetime of the bond. Conversion becomes attractive as soon as the share price on the stock exchange exceeds the conversion price.

3.4 Types of Convertible Bonds

• Regular Convertible Bonds- Several companies issue these types of convertible bonds, usually to the public. Regular convertible bonds come with a fixed maturity date and at a preset conversion price. The issuing company offer periodic interest payments to all its investors till the maturity date in exchange for investing in these types of bonds.

  Upon maturity, the investor can make a decision whether to convert the bonds to equity shares of the issuing company at the predetermined conversion price or redeem the bonds at their face value.

  However, these bonds only give rights to investors and not an obligation to convert into shares.

• Mandatory Convertible Bonds- These bonds are the opposite of regular convertible bonds. These bonds obligate the investor to convert bonds of the issuing into shares upon maturity. Mandatory convertible bonds continue to make regular interest payments till the maturity date upon which bonds are compulsory converted into equity shares. Several companies offer a higher interest rate on mandatory convertible bonds because they force investors to convert their bonds into equity shares.

• Reverse Convertible Bonds- In this type of convertible bond, the investor or the bondholder has the obligation or right to convert their bonds. It is not the same as regular and mandatory convertible bonds. The issuing company holds all the rights to convert into equity shares at a predetermined price upon maturity with reverse convertible bonds. However, the issuing company may select to either convert the bonds into equity shares or retain them as such depending on the circumstances and the share price at the time of maturity.

3.5 Advantages of Convertible Bond

1. Convertible bondholders receive only a fixed, limited income until conversion.

   This is a great advantage for the company because a bigger chunk of the operating income is available to the common stockholders. If a company does well, it has to share its operating income only with the newly converted shareholders.

2. Voting control is in the hands of common stockholders.

   Bond holders cannot vote for directors. So if the management level of a company is concerned about losing voting control of the business and need an alternative means of financing, selling convertible bonds will be more advantageous than using common stock for funding.

3. They help a corporation in securing equity financing in a delayed manner- Because it takes time for the bondholders to trade their bonds for stock, this delays the common stock and the earnings per share dilution.

4. Corporations can sell bonds at a lower coupon rate.

   Because there is an option to purchase stocks, companies can sell convertible bonds at a lower coupon rate than standard bonds.

3.6 Disadvantages of Convertible Bonds

1. The company has the right to forcibly convert them.

   The issuing company has the right to call for forced conversion usually when the price of the stock is higher than the amount it would be if the bond were redeemed. Another instance is during a bond's call date. This means there is a cap on the capital appreciation of the bond.

2. They are complex securities.

   Most new investors tend to be confused if convertible bonds are stocks or bonds because of their characteristics. You also have to consider certain factors that can affect the price of these bonds. These can include the market for the underlying stock and the climate of the interest rate.

3. They are riskier.

   If the issuing company files for bankruptcy, holders of convertible bonds have a lower priority claim on the corporation's assets. The secured debt holders have to be paid off first.

4. They are traded at a premium to the current trading price.

   Investors have to allow the stock to reach the conversion price in order to make the conversion effective.

5. They can be disadvantageous to the issuing company.

   These investments can dilute the EPS of the corporation's common stocks, not to mention the company also risks losing control.