Convertible bonds: purpose, types, benefits and risks

2024 Author: Henry Conors | [email protected]. Last modified: 2024-02-12 02:40

In a market economy, open competition, accelerated modernization of equipment and technologies, it is increasingly difficult for commercial enterprises to stay afloat and increase their momentum towards intensive development. Investment activity is one of the tools that can greatly contribute to this. In turn, investment activities have their own tools. According to experts and analysts, they have completely different efficiency and associated risks. The purpose of this article is to reveal the concept of convertible bonds as one of the instruments of investment activity, to understand their goals, types, and to understand in detail what are the benefits of using them and what risks it entails.

Convertible bonds. What is it?

To make it easier to understand the essence of this phrase, you need to remember what a bond and conversion are.

A bond is, first of all, a security that reflects the debt obligation of the issuer and allows its owner to receive a known income frominitially agreed frequency during the period of ownership, and then return it to the issuer at a certain time, having received back their investment.

Issuer is an enterprise that issued a bond with the expectation of raising borrowed funds from investors.

The owner of the bond is an investor.

For example, an enterprise produces products that are in demand in the current period, has certain competitive advantages, but according to analysts, in the short term, the enterprise may lose its position due to the use of outdated equipment, which will not allow them to increase production with a predicted increase in demand for this product. Modernization of the equipment is necessary, but there is no money. There are many options for raising money, one of them is the issuance of bonds. That is, the company attracts money from investors and gives them a document on its promissory note. This document contains all the parameters of the transaction. During the validity period of the debt obligation, the investor receives income on it (the issuer pays interest for using the investor's money), and at the end of the agreed period, the issuer returns the money to the investor and takes back the debt obligation (bond). If so stipulated in the transaction, the investor can resell the bond to another investor and receive the money at the market value of the debt ahead of schedule.

Conversion - transformation. If we are talking about securities, then this is the transformation or exchange of one type for another. For example, the exchange of shares for bonds, and vice versa.

From here it is very easy to define convertible bonds. These are ordinarybonds that include an additional option - exchange for shares of this issuer at a certain time.

That is, ordinary bonds can only be returned to the issuer at the end of the term in exchange for their own money, while receiving income during their possession, or resold ahead of schedule to other investors.

Convertible bonds give the right, in addition, to exchange them for the issuer's shares at specified time intervals. That is, the investor has the opportunity to choose one of the options - to use them as ordinary bonds or exchange them for shares.

Main parameters

Any security, like any deal, has parameters (conditions). Main parameters of convertible bonds:

1. Nominal value (this is its value at the time of purchase from the issuer). That is, the nominal value of the bonds is equal in aggregate to the amount that the investor lent to the issuer, and the issuer will have to return it to the investor at the end of the bond period.
2. Market value. The value of bonds may vary depending on the growth and development of the enterprise and the demand for the securities of this issuer from other investors. In different periods, it can be higher or lower than the nominal value. Usually fluctuations are up to 20%. At market value, bonds can be sold by another investor, but the return to the issuer is only at par.
3. Coupon rate. This is the interest rate for the use of borrowed funds that the bond issuer pays to the investor.
4. Frequency of coupon payments –interest payment interval for the use of borrowed funds (every month, quarterly, semi-annually or annually).
5. Maturity is the duration of the bond. That is, the period for which the investor lends money to the issuer. Maybe 1 year, and even 30 years.
6. The conversion date is the date on which it is possible to exchange for shares. One end date is possible, or the period in which this can be done, or several fixed dates.
7. Conversion ratio - shows how many bonds with a certain par value are needed to receive one share.

Main species

Before issuing convertible bonds, an enterprise conducts an in-depth analysis based on the purposes of their issuance, the market situation, the timing of raising money, targeting a certain circle of investors, etc. Based on this, the conditions that it can lay in bonds observing two parameters - the maximum benefit for themselves and attractiveness for the investor. Therefore, there are many varieties of convertible bonds. Below are some of them:

1. With zero coupon. This means that there is no interest income on them, but such bonds are initially sold at a discount (that is, they are sold at a price below face value and returned at face value). This difference is the discount, which is the investor's fixed income.
2. With the possibility of exchange. These bonds can be exchanged not only for the shares of the issuer that issued them, but also for the shares of anotherissuing company.
3. With obligatory conversion. The investor must make a mandatory conversion into shares during the circulation period of this bond, there is no choice to sell or exchange.
4. With a warrant. That is, the bond is bought immediately with the right to buy a fixed number of shares at a fixed price, which is immediately higher than their market value at the time of purchase. But the coupon rate of a convertible bond will be lower. There are certain risks, but if the issuing company prospers, then the investor will exchange shares in a certain period for shares at a fixed price, which at that time will be below the market price. This will be compensation for the lost interest on the coupon.
5. With embedded options. The calculation of convertible bonds with an option gives the investor an additional large discount, but mainly if the maturity period is long (at least 15 years). The investor has the right to demand early repayment of debt obligations (the date of possible repayment is negotiated at the time of purchase and may be more than one).

The use of convertible shares and bonds as an investment instrument has a number of advantages for both the issuer and the investor. However, there are a number of risks for both participants in the transaction. Below are some of them.

Benefits of use for the issuer

1. Raising borrowed funds through a bond issue is cheaper than raising credit funds, because the coupon rate is much lower than the interest on the loan.
2. Releaseconvertible bonds can allow an enterprise to raise significantly larger resources.
3. Issuing bonds is much cheaper than issuing shares. The possibility of converting into shares makes it possible to issue additional shares with the possibility of saving on this process with a delay in the period.
4. For the issuance of bonds, minimum requirements are applied to the enterprise, unlike, for example, the assessment by the bank when issuing a loan. However, the company's credit rating is important.
5. After the conversion, equity increases and long-term debt decreases.

Benefits of use for the investor

1. Investment of funds, having a guaranteed fixed income and the opportunity to receive the issuer's shares at a price below the market (this is beneficial if the company is successful). If the price of the company's shares falls at the time of conversion, the investor has the right to refuse the conversion and use the convertible bond as a simple bond. In this case, the investor is more flexible in making a decision to receive more profit.
2. As the market value of the issuer's shares grows, so does the price of bonds. This makes it possible to receive additional profit, despite the fact that the right to convert was not exercised.

Issuer risks

1. A business is always at risk of financial difficulties, which can make it difficult to service debt.
2. May have problemswhen planning activities, despite the fact that when issuing convertible bonds, the issuer makes various possible forecasts. This is a consequence of the fact that the decision to convert or redeem a debt obligation is made only by the investor, and not by the issuer.

Risks for the investor

1. If a mass conversion starts, liquidity will decrease significantly, this will complicate trading in the securities market, which means that there is a risk of losing potential profits.
2. Lower yields than regular debt. If the share price remains unchanged or falls, the investor will refuse to convert and will not receive the expected profit.

Use in Russia

The experience of using convertible bonds in Russia is not as great as in Western countries and the US. However, large companies resort to this method of raising borrowed funds. The maturity of bonds is usually five years. Although it can be from 1 to 5 years. As a rule, the par value of a bond is 1,000 rubles.

Large companies with high credit ratings can issue these bonds with an aggregate par value of up to $1.5 billion. Smaller companies can raise up to $500M.

Mostly bonds with mandatory conversion are used, which allows the issuer to significantly reduce the coupon yield, or eliminate it altogether.

Conclusion

In essence,A convertible bond consists of a common bond and an additional free exchange option for a predetermined number of common shares at a fixed price. Such a bonus, in turn, reduces the coupon rate of such a bond, in contrast to a conventional bond. This method of raising borrowed funds is widely used both in Russia and abroad, as it provides a number of advantages for both issuers and potential investors. However, not all types of these bonds are used in Russia yet.