How do convertible bonds work?

Companies wanting to raise capital can issue a product called convertible bonds. In this article we discuss how these products work.

Why issue convertible bonds?

Companies which are in the initial growth phase may find it hard to obtain financing from lenders due to a poor credit rating. They may issue convertible bonds to investors to raise funds for expansion or a new project.

How do convertible bonds work?

Convertible bond holders receive regular interest payments with a pre-agreed coupon rate. At maturity date, investors have a choice to receive the principal or they can convert their convertible bond to shares.

If the stock price has deceased, the investor can decide to receive the principal on maturity. If the stock price has increased, the investor can elect to convert their convertible bond to shares. The conversion ratio is used to calculate how many shares the investor should receive. The coupon rate and conversion ratio are outlined in the prospectus.

Advantages of convertible bonds

Investors are offered regular interest payments which are not guaranteed with equity products.  However, convertible bonds are considered riskier regular bond products.

Investors are also offered capital growth with these products as they can convert their holdings to shares at maturity if the share price has increased.

In the event the company defaults, convertible bond holders will be paid before shareholders.

Companies can pay a lower interest rate for convertible bonds to investors compared to corporate bonds as they offer the option to convert to ordinary shares.

Lauren Hua is a private client adviser at Fairmont Equities.

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