Convertible bonds are typically fixed-rate bonds issued by a company, the terms of which allow the holders of the bonds to convert them into ordinary shares of the company at a prescribed conversion price and during a prescribed conversion period.
Convertible bonds can therefore be seen as a combination of two separate financial instruments:
- A fixed-rate bond
- An embedded equity call option
This combination brings a number of potential benefits for both issuers and investors, compared to either plain vanilla bonds or ordinary shares.
The issuing company receives up-front payment for ordinary shares to be issued at a later date, customarily at a premium to their market price. To the extent that a company considers its ordinary shares to be undervalued at the time of pricing of the bonds, the issue of convertible bonds may be an attractive alternative to issuing ordinary shares. In addition, investors demand a lower interest rate on convertible bonds than on plain vanilla bonds, given the additional value of the equity call option. This will be helpful for a company seeking to better manage its debt service and leverage ratios. Furthermore, if the company’s ordinary shares perform, the bonds will convert into ordinary shares and the company will not need to repay its borrowings. Finally, the company is provided with access to a broader investor base, as convertible bond investors consist of both hedge funds and “long-only” investors.
Investors, on the other hand, have the benefit that, even if the ordinary shares of the company perform poorly, the bonds continue to provide a fixed rate of income for them through the coupon and a protected return of principal on their final maturity date. In addition, if the company were to become insolvent or be liquidated, an investment in convertible bonds would have even rank with the company’s unsecured debt and rank ahead of an investment in the ordinary shares of the company in insolvency proceedings. At the same time, investors will be able to participate in a potential upside in the performance of the ordinary shares of the company. This is because the option to convert the bonds into ordinary shares is set at a fixed price, and the holder of the bonds therefore benefits from any increase in the market value of the ordinary shares above that fixed conversion price.
Of course, convertible bonds also have a number of potential downsides for both issuers and investors.
If you would like to learn more about convertible bonds, please click on the link below to download a copy of the European edition of Mayer Brown's Convertible Bonds – An Issuer’s Guide, or request a hard copy. The guide is primarily intended to help the treasury teams and in-house Lawyers of corporate borrowers assess the merits of convertible bonds to their funding programs and to better understand their commercial terms, timetable and related documentation, but we believe that other market participants (such as underwriting banks, law firms or other financial and legal advisers) will also find it helpful.
Download Convertible Bonds - An Issuer's Guide