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Definition: Convertible Bonds
Convertible bonds are the bonds that are convertible into shares of common stock, at a fixed price, at the option of the bondholder. Convertibles have a lower coupon rate than nonconvertible debt, but they offer investors a chance for capital gains in exchange for the lower coupon rate. Bonds issued with warrants are similar to convertibles.
It is a hybrid security having features of both debt-&-equity. It allows the holder to participate in further growth in company’s value. The investor receives the potential upside when he converts it into equity, whereas it protects its downside with cash flow from the coupon payments and the return of principal upon maturity.
Issuer receives the benefit in the form of reduced interest payments. But the shareholders equity is decreased because of dilution of stock expected when bond holders convert their bond into new shares.
Types of convertibles:-
Plain convertible bonds: These bonds may or may not be redeemable prior to the final maturity date. There is an option with the bond holders to convertthe bonds into the shares of the issuing company, generally at a pre-determined rate.
Contingent convertible Bonds: The bond holder is allowed to convert into stock after paying a conversion premium only if the price of the stock is at a certain percentage over the conversion price. For example: If a contingent convertible with a $20 stock price on issue, 20% conversion premium and a contingent conversion trigger of 110%, can be converted at $24 only if the stock trades above $26.4 ($24 x 110%) over a specified period of time.
Mandatory convertible bonds:These bonds should be mandatorily converted on maturity into a fixed number of equity shares.These securities are for a short duration. Mandatory convertibles generally give yields higher than that of theunderlying equity shares.