Define Convertible Bonds
Bonds are common debt instruments that companies use to raise funds. These have an interest rate to give the investors a profit, and they have terms varying from several years to only a couple days. Stocks, on the other hand, are company equity that businesses sell in order to raise capital. Stocks are more dependent on the success of the company and market conditions than bonds. Convertible bonds combine some of the benefits of both into one package.
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Corporate Bonds
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Corporate bonds are used only to raise funds by increasing the company debt. Governments use bonds for different purposes, sometimes to change the economy or to pay off debts in other areas, but corporate bonds are used only for fund raising, and only corporate bonds can be convertible bonds. These debt instruments are typically released in a series and investors will buy them depending on interest in the company and market value.
Definition
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Convertible bonds start out as normal bonds, but with one special exception: The investor who buys the bond has the right to exchange it for stock in the same company, known as a convertible option. This gives the investor much more leeway in both earning money and selling the bond. The value of the bond remains the same, even though the stock of the company may change in value.
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Options
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An option is a right that an investor has to activate some type of policy regarding a share or bond. The option to convert convertible bonds to shares typically has a time limit, so the investor may only have a certain amount of time in which to act. Also, the option usually specifies not only the price of the bond but the price of the stock, for which the investor can trade in the bond.
Benefits
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Convertible bonds are extremely flexible. If the investor wants to, the low-risk bond can be exchanged for a higher-risk common stock at any point during the given time frame. This allows investors to speculate on varying stock prices and make money by switching to stocks at the proper time. This built-in flexibility also makes convertible bonds more attractive to investors, so they can be sold more easily at a higher premium than other types of bonds.
Considerations
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Converting the bond will not do the investor any good if the market value of the stock is below the specified price of the option. Instead, the investor will lose money. Convertible bonds are useful when the stock price of the company is rising in value. Also, convertible bonds are difficult to represent in accounting statements and may cause difficulties when determining the value of a business.
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References
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