Hybrid Securities – What are Convertible Bonds?

What are convertible bonds?

Convertible bonds are corporate bonds with a call option (right to purchase) on the company’s shares. It’s a hybrid investment that combines features of both bonds and stocks, offering the fixed income of a bond and the potential for growth from stock ownership.

These can be attractive to issuers because they bear a lower coupon than a straight bond. The investor gets a lower running return but the chance for a capital gain as he will only convert when the share price is above the conversion price. The convertible bondholder is in a similar position to a holder of a bond plus warrant (a call option on the shares) but different in that, at conversion, the convertible bondholder will give up the bond to exercise the call option. The bond-with-warrant holder can exercise the warrant for cash and keep the bond. In practice, bond-with-warrant issues usually split after issue with the bonds and warrants held by different investors.

An example of convertible bonds would be a company issuing bonds that can be converted into shares of the company’s stock. Suppose a company wants to raise capital for growth but is not yet ready to issue stock or wants to avoid diluting existing shareholders. The company decides to issue convertible bonds that offer investors a fixed income, but also the option to convert the bond into shares of the company at a predetermined price. If the company performs well and the share price increases, the bondholders can convert their bonds into shares and benefit from the increase in value. However, if the company does not perform as expected and the share price falls, the bondholder can choose to continue receiving the fixed income payment or to convert their bond into a smaller number of shares.

How do Convertible Bonds reflect in financial statements?

  1. Balance Sheet: Convertible bonds are listed as a liability on the balance sheet and are separated into the bond portion and the conversion option portion. The bond portion is recorded at its face value, while the conversion option is recorded as an equity instrument and is valued using option pricing models.
  2. Income Statement: Interest payments on convertible bonds are recorded as interest expense in the income statement. If the bonds are converted, the difference between the face value of the bonds and the conversion price is recorded as a gain or loss.
  3. Cash Flow Statement: Interest payments on convertible bonds are recorded as a cash outflow in the investing activities section of the cash flow statement. If the bonds are converted, the face value of the bonds is recorded as a cash inflow in the financing activities section, and the conversion option is recorded as a cash outflow in the investing activities section.

Benefits of Convertible Bonds

  1. Hybrid Investment: Convertible bonds offer both the fixed income and equity potential of traditional bonds and stocks, respectively.
  2. Potential for Capital Appreciation: Holders of convertible bonds have the opportunity to benefit from the appreciation of the underlying stock.
  3. Lower Volatility: Convertible bonds tend to be less volatile than stocks, as the bond component provides a level of stability.
  4. Higher Yields: Convertible bonds often offer higher yields than non-convertible bonds of similar credit quality.

Risks of Convertible Bonds

  1. Credit Risk: As with any bond, convertible bonds are subject to credit risk, meaning the issuer may default on interest or principal payments.
  2. Market Risk: The value of convertible bonds can be impacted by changes in interest rates, market conditions, and the performance of the underlying stock.
  3. Conversion Risk: Convertible bonds may not be converted into stock if the stock price does not reach the predetermined conversion price.
  4. Liquidity Risk: Convertible bonds may be less liquid than other types of bonds or stocks, making it more difficult to sell them when needed.

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