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What Is A Convertible Bond?

Some companies have chosen to use a financial instrument called a convertible bond to raise cash. Some of the blue chip shares within the Straits Times Index (SGX: ^STI) that have utilised convertible bonds before include CapitaLand (SGX: C31)Golden Agri-Resources (SGX: E5H), and Noble Group (SGX: N21). But what exactly is a convertible bond? Why would a company 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.

What is a Convertible Bond?

A convertible bond is basically a hybrid debt instrument. 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 of the company. Each bond will have a conversion ratio which is simply the number of shares that one bond can be converted into. There might also be a conversion premium that bond holders might need to pay to convert the bond into shares.

Are Convertible Bonds Better?

A company might choose to issue a convertible bond because the instrument generally has a much lower interest rate as compared to a traditional bond. Investors of the bond are willing to take a lower interest rate as a convertible bond has the ‘conversion-option’, which often makes it more valuable than a traditional bond.

Sometimes, a listed company might also choose to issue convertible bonds instead of issuing stock, to avoid the chance that the market might think that the company’s share price is over valued. Issuing convertible bonds becomes another way (since the bondholders can convert to equity) of raising money through the issuing of stock.

Issuing convertible bonds is one way for a company to minimize negative investor interpretation of its corporate actions. For example, if an already public company chooses to issue stock, the market usually interprets this as a sign that the company’s share price is somewhat overvalued. To avoid this negative impression, the company may choose to issue convertible bonds, which bondholders will likely convert to equity anyway should the company continue to do 

What are the possible impacts for shareholders?

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.

Firstly, 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. If there is a risk of a huge dilution from the convertible bondholders, your equity in the company might be worth less than it appears to be.

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 bondholders tend to convert only when the convertible option is in the money.

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.

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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 does not own any companies mentioned