Why Do Companies Choose Convertible Debt?
Corporations can raise capital in one of two ways -- equity or debt. They can either sell stock or borrow from a bank/issue bonds. Convertible debt, or convertible bonds, is a form of borrowing that has an "equity kicker" -- it can be converted into shares of stock at some future date under certain conditions.
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Bond vs. Stock Issuance
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Bonds are generally considered safer than stocks. Bonds are debt securities that pay regular interest (semi-annually) and carry a promise of return of principal at maturity. Stocks may or may not pay dividends and are perpetual securities: a corporation never has to repay them. Bonds are considered senior securities in that bondholders have priority claims over stockholders on corporate assets in bankruptcy liquidation. If a corporation declares bankruptcy, stockholders usually lose their entire investment whereas bondholders, especially senior or secured bondholders, have a chance to recover a good part of their investment from the proceeds of corporate asset sales.
Stocks: Unlimited Upside
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If a corporation succeeds and goes on to become the next Microsoft, the stockholders reap all the benefits. All that the bondholders get is the interest and repaid principal.
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Convertible Bonds
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Convertible debt gives investors a combination of both: the income and safety of bonds and an opportunity to participate in the upside if the bonds are later converted into stock.
Corporate Advantages
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By making convertible debt attractive to investors, it is easier for corporations, especially risky ones, to raise capital. Investors may be hesitant to buy stocks in new risky ventures so they prefer to finance them through bonds, but if a corporation succeeds, they want to participate in the upside by converting the bonds into stock later. The convertible feature allows corporations to pay less interest on convertible than on non-convertible bonds. Some corporations issue convertible debt after their stock has risen a lot and investors are overly excited about the company's prospects. They are eager to buy convertible bonds because they expect the stock to continue to rise so they can benefit from its appreciation later on by converting, but if the stock declines instead, the bonds may never be converted, so the corporation will have saved on lower interest payments without ever having to issue more stock.
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