Convertible Bonds
Bonds are some of the most sought-after investment avenues in India. A form of debt instrument, investing in bonds means that you are loaning some money to a business with the guarantee of a return. Offering lower returns than stocks, bonds are handy debt financing instruments for companies and assure a fixed return to investors. A low-risk profile makes corporate bonds the ideal investment choice for investors with low-risk tolerance.
What is a Convertible Bond?
Convertible bonds are fixed-income debt security instruments that convert to securities issued by businesses to raise capital under financial duress. These bonds exhibit hybrid security characteristics, offering regular interest payments and allowing investors to convert the bond into company equity shares & sizeable conversion premiums.
Companies with sub-par credit ratings but good growth potential issue convertible bonds to gain necessary capital funding while offering lower yields to investors. Compared to regular corporate bonds, the interest payments of these bonds are much lower than traditional fixed income instruments. Still, the option to convert when the underlying stock price rises make them attractive to investors.
The coupon payments of convertible bonds are comparatively lower than common stocks. The conversion option is a sweetener for investors, which is why the better the price of the issuing company’s stock, the lower the bond yield.
Types of Convertible Bonds
1. Vanilla Convertible
Vanilla convertible bonds are regular convertibles that come with a set conversion price. The conversion price is the stock price that the convertible bond must acquire to offer a decent return when converted. These bonds have a fixed maturity date and offer a slightly lower interest rate than standard corporate bonds.
At the maturity date, investors can turn vanilla convertible securities into equity shares at the current stock price and gain a better conversion premium. In addition, they can redeem the bonds at their par value if they forfeit conversion.
The generic rule for vanilla convertibles is exercising the bond conversion option when the associated share price exhibits a rising trend.
2. Embedded Options
Most convertible instruments have certain features embedded in them. In most cases, they have a call-and-put option integrated wherein the issuer can force bonds to mature at a fixed, predetermined price. The put option facilitates investors to sell a bond at mutually agreed prices.
3. Mandatory Convertible
Mandatory convertible bonds have a particular conversion date and must be converted to stocks once that date is reached. Mandatory convertibles usually come with short tenures and often carry higher interest rates as business force investors to convert.
4. Exchangeable Bonds
Exchangeable bonds are just like generic convertibles, albeit with one unique feature: the underlying stock belongs to a different issuing company.
5. Contingent Convertibles
A relatively secure type of convertible bond, these types of convertible bonds need to reach specific prices above their conversion price before they can be transformed into stocks. Therefore, the stock value appreciation must be above the conversion price. In addition, it must trade in the stock market at that appreciated value for a certain period before it can be converted.
6. Foreign Currency Convertible Bond
The returns from foreign currency convertible bonds come in a currency other than what the issuing company uses. A prominent benefit of FCCBs is that the interest rate of these bonds does not depend upon the currency exchange rates.
7. Reverse Convertibles
Somewhat different from their counterparts, reverse convertible bonds can be converted into either cash or security during maturity. The issuer holds the conversion rights and can either pay the investor in cash or hand over a set amount of shares per the conversion ratio.