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How You Can Make Sense of a Convertible Bond

There are many types of instruments that a company can issue to raise money. In Singapore, some of the more commonly used ones include a Rights Issue, New Share Issue, Warrants, and Convertible Bonds.

In here, we look at what a convertible bond is; why a company might choose to issue such a financial instrument; and more importantly, what does it mean for you as an investor if you happen to invest in a company with convertible bonds outstanding.

Some of the blue chip shares within the Straits Times Index (SGX: ^STI) that currently have convertible bonds outstanding include CapitaLand (SGX: C31)Golden Agri-Resources (SGX: E5H), and Noble Group (SGX: N21).

Outside the index, we have shares like Keppel Land (SGX: K17) and Ezra Holdings (SGX: 5DN) that fall into that category.

What is a Convertible Bond?

A convertible bond is a hybrid debt instrument that a company issues to raise money. As a bondholder of a convertible bond, instead of simply just receiving an interest like a traditional bond, he or she will also have an option to convert the bond into shares (a.k.a. equity). Each bond will have a conversion ratio which is simply the number of shares that one bond can be converted into.

Why Convertible Bond?

A company might choose to issue a convertible bond because the instrument typically has a much lower interest rate as compared to a traditional bond. That’s due to the fact that a convertible bond has the ‘conversion-option’, which often makes it more valuable than a normal bond in the eyes of many participants in the financial markets.

Furthermore, if the management of a company has a need to raise additional funding at a time when they feel that their shares are undervalued, it might not be a wise decision to raise funding through issuing equity. In such an instance, a convertible bond might prove to be a more palatable choice.

What does it mean?

For an investor, if you are preparing to invest into the common shares of a company with convertible bonds outstanding, there are a few things to take note of.

First off, it is important to know the extent of any dilution you might face by checking up on the number of shares that can be converted from all the convertible bonds the company has; generally speaking, the larger the extent of dilution possible, the riskier the investment becomes.

Secondly, you should compare the conversion price of the convertible bonds with the company’s current share price to see if there is even a possibility for conversion; if the conversion price is way higher than the current share price, chances of conversion by any of the convertible bond holders is minimal as it would entail the prospect of losing money during the conversion process for the bond holder.

Lastly, be aware that in all but the rarest of cases, a convertible bond, once converted into common shares, cannot be turned back into a bond. Any new shares that are created from the conversion process would remain there until the company in question decides to do something about it.

Foolish Bottom Line

Convertible bonds might be a useful instrument for a company to raise money. However, as an investor in common shares of a company, we should be mindful of how the instrument – or any other financial instrument for the matter – might affect our investment and not be caught unaware of any potential danger.

As the saying goes, “An investment in knowledge pays the best dividends.” Knowing the potential pitfalls of any investment might even prove to be even more lucrative than the best dividends you can find.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.