Convertible Bonds

Definition

The term convertible bond refers to an indenture issued by a company that is exchangeable for shares of common stock or the equivalent amount of cash.  Convertible bonds are considered a hybrid security, since they contain both debt and equity features.

Convertible bonds are typically issued for a term of 10 years or more.  As such, they represent a long term obligation of the company, and are shown in the long term liabilities section of the balance sheet.

Explanation

Issuing long-term bonds represents an important source of financing for many large companies.  Convertible bonds typically carry maturities of 10 years or longer and are classified as long-term debt obligations.

Since this feature provides the investor the option of converting the bond into common stock or cash, it would carry a lower coupon rate than debt not possessing this feature.  This type of security would be attractive to investors if they believed the issuing company's stock price will increase over time.

Companies that issue convertible bonds are usually smaller (in terms of market capitalization), with less-than-optimal credit ratings, that appear to offer significant growth potential.  These securities offer the holder the opportunity for convertible arbitrage, which is taking a long position in the bond, while assuming a short position in the company's common stock.

Convertible bonds provide the issuing company with the opportunity to lower interest payments on its debt.  In addition, as this debt is exchanged for common stock, the leverage of the company decreases.  Unfortunately, this same mechanism decreases the value of common stock, as shares will be diluted when exchanged.

The prospectus of these securities will usually inform investors of factors such as the conversion price or ratio, redemption or conversion dates, in addition to the coupon rate and yield to maturity.   Finally, convertible bonds may contain additional features such as the ability for the issuing company to redeem, or call, the debt prior to its maturity.

Related Terms

liabilities, long-term liabilities, interest expense, term and serial bonds, dilutive securitiesvaluing convertible debt, market value method, book value methodinduced conversions