What exactly are convertible bonds? These are debt securities that uniquely differ from traditional bonds. Investment in convertible bonds can be complex and risky and investors need to understand how they work before investing in such securities. Here are a few basic things investors need to know about convertible bonds:
It is a type of debt security that offers investors with the option to convert their bonds for a pre-specified number of shares during the lifetime of the bond. The bond conversion can be conducted only with the issuing company. It is a type of hybrid security which possess features of both equity and debt securities.
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Convertible bonds are not classified into formal categories in the financial market. But while referring to the types of convertible bonds underwriters often use the following terms:
This is the most basic type of convertible bond. Here the investors can convert their bonds into a certain number of shares at a pre-specified conversion price at the maturity. During the life of the bond investors are offered coupon payments that come with a fixed maturity date. At maturity, the investors become eligible to get a nominal value of the bond.
See Also: Taxation of Debt Funds
In this type, the investors must mandatorily convert their bonds to shares at the time of maturity. Here the bonds come with two conversion price. The first price is meant to delimit the price at which investors are usually given equivalents of its face value in shares. The second price is meant to provide a limit to the price investors are eligible to receive above its face value.
Reverse convertible bond refers to a type of convertible bond where the issuer of the bond has the option to buy back the bond from investors in cash or convert the bonds to equity at a pre-specified conversion price at maturity.
Investing in convertible bond requires sound knowledge and investors need to conduct thorough research before investing in convertible securities as they can be complex and risky. While investing investors must know how the company is going to perform over the life of the convertible bond. If you do not have a positive outlook of the company, you must refrain from such investments.
Investment in convertible bonds is conducted through a broker or fund houses. Several major fund houses offer mutual fund schemes that invest in convertible bonds. It must be kept in mind that portfolios of convertible bonds perform similar to high-dividend equity funds. Investors can use such investments to diversify their portfolios. But such investments are advantageous for investors who have a major portion of investment in debt securities. Investors who have primarily invested in equities should consider these investments with caution.
To understand the risk factor associated with convertible bonds, let’ take a closer look:
Convertible bond exposes investors to both interest rate risk as well as default risk. As we know bond prices decline when there is a rise in interest rate, thus investors must take care of interest rate movements while investing in such securities. Also, due to the equity component, convertible bonds also suffer from market risk.
Investors must also remember that most convertible bonds are callable. Thus a sudden increase in the prices of the stock may lead to the bond being called away thereby capping the investors gain. Experts believe investors must consult market professionals before investing in convertible securities so that they know the ins and the outs of such investments.
See Also: Invest In Short Term Debt Funds
Some of the key advantages of convertible bonds are given below:
Usually, investors are paid lower interest rates on convertible bonds than regular bonds. Investors are willing to accept such interest rate due to the equity factor associated with it. This helps the issuing company to pool money from investors at lower interest rate thus helping them to save some money on their interest payment.
Since interest payments are tax-deductible, convertible bonds allow the issuing company to benefit from interest tax savings that are not possible in equity financing.
Convertible bonds are a convenient way of financing for companies which are not willing to deplete their equity shares in the short or medium term but are comfortable to do it in the long-run.
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