The convertible bond is one kind of equity-linked bonds. The term of the bond entitles bondholder to convert bonds into shares of the company or another company in the same group, at an agreed-upon conversion price, among a fixed period. The reason why it is made in this form is that the issuer can benefit from four aspects as follow,
(1) better terms. A convertible bond have a lower interest rate, less restrictive covenants or the subordination of bondholders' claims to those of other unsecuried creditors. As W Klein pointed out, the issuance of convertible bonds allows the company to raise money in a cheaper way while the company's appearance as a good credit risk will not be impaired.
Exception in eurobonds: it always contain a put option entitling the investor to call for repayment at certain point in order to give the investor a better rate of return. This would help to remove the risk of a fall in the value of the shares.
(2) Longer maturity. Since longer conversion period gives investors a longer time to exercise the conversion right, which makes the option worth more, therefore the company can successfully issue bonds with a longer maturity than otherwise being acceptable. A longer maturity means the company will not have the pressure on reserving a great amount of money to repay in a short period, instead they can use the money for further long-term investments. In other words, the company can borrow money for a long time but in a relatively low interest.
(3) Access to investors. Due to the back-stop protection of bonds, i.e. bonds will be repay in fixed income on due date.
(4) Deferred equity financing. Issuing convertible bonds is like the shares are paid in advance.
With the achievements above , what was loan capital now becomes equity capital so that the gearing, the ratio of the debt to equity, is improved. On the other hand, the disadvantages are thatissuer may subject to greater disclosure requirements and, when investors buy shares at below the market price via convertiable bond, the value of exsiting shareholdings in the company is diluted.
The reasons (in the investor's view) why there is a market for convertible bond are (1) investors will want to buy this package is because they are optimistic at the prospective rate of growth of the company, believing that they can get cheap shares via convertible bonds when share price goes up. (2) investors, who desire a combination of portfolio might interested in convertible bonds because convertible bonds are safer than preferred or common shares. The value of the convertible bond will only fall to the value of the bond floor.
In sum, the investor can be benefit from the potential upside of conversion into equity while protect the downside with cash flow from the coupon payments.
When drafting the terms of the bond, the first lines must be the conversion price. The conversion price is the shares' price for which the bondholder would pay when transfering the bond to shares. It may be in a fixed amount for the entire conversion period or it may be stepped-up at specified intervals. The price is nomally higher than the market price of the underlying shares at the time of issue of the bonds. The difference between is called the conversion premium.
One downside of convertible bonds is that the issuing company has a right to call the bonds. In other words, the company has a right to forcibly convert them. Forced conversion occurs when the price of the stock is well above the conversion price, e.g. 130 per cent, or this may occur at the bond's call date. If there is a trustee, there might be a "widows and orphans" clause whereby the trustee can convert on behalf of holders' interest.
If the issuer is in the event of default in which triggers the acceleration, the conversion period may be expired. This is a bondholder risks. The suggestion is that...