Bonds refer to giving a loan to the company by the investor in return for interest payment which may be paid annually or semiannually and the investor gets principal repayment on fixed date of maturity of the bond. A convertible bond is a type of bond which gives the holder of the bond right to convert his or her bond into equity shares after a fixed period of time. In order to understand the concept of convertible bond let’s look at some of the advantages and disadvantages of convertible bond –
Advantages of Convertible Bond
- First and foremost advantage of the convertible bond is that it gives the holder of the bond right to convert his or her bonds into equity shares which in turn results in bondholder enjoying the benefits of equity shares also.
- Another benefit of a convertible bond is that since the convertible option is attached to these bonds company has to pay a lower rate of interest on this type of bond as compared to regular bonds which carry a higher rate of interest. Hence as far as the company is concerned it saves expenses in the form of lower interest payment on this type of bonds.
- Another merit of a convertible bond as far as the investor is concerned is that chance of investor making windfall gains is there because if the company is making good profits and at the time of conversion price of equity share is good than investors can make the good amount of gains from his or her holdings. So for example, if an investor has 1000 bonds at $100 and now on conversion, he or she gets 500 equity stocks and the price of those stocks are trading at $300 then the investor will get $150000 in which $50000 being profit due to stock price rising.
Disadvantages of Convertible Bond
- The biggest disadvantage of a convertible bond is that when these bonds get converted into equity shares it leads to dilution of the stake of the owners of the company which does not go well with owners as well as equity shareholders of the company.
- Another limitation of convertible bond is that those who invest in these bonds get lower interest rate as compared to regular bonds and though lower interest rate is good for the company but as far as conservative investors are concerned they will not be happy with lower return and will stay away from this type of bonds issued by the company.
- Another demerit of a convertible bond is that if the prices of the shares of the company at the time of conversion are trading at lower valuation then it can lead to the loss for the bondholder. So for example, if an investor has 1000 bonds at $100 and now on conversion, he or she gets 500 equity stocks and the price of those stocks are trading at $150 then the total valuation of investor holdings is $75000 as opposed to the investment of $100000. Hence in a way bondholder is exposed to the risk of equity market due to convertible bonds.
As one can see from the above that convertible bond has merits as well as demerits and any company before issuing convertible bond should keep above points in mind and then take the decision accordingly.