What is a Convertible Debt?
Convertible debt, also known as convertible bond, is a debt instrument that can convert into equity shares later. It is hybrid securityHybrid SecurityHybrid securities are the combined characteristics of two or more types of securities, usually both debt and equity components. These securities allow companies and banks to borrow money from investors and facilitate a different mechanism from the bonds or stock offering.read more as it contains both debt and equity features and offers added advantages to the holder.
- Like a common bond, the company issues convertible debt with a coupon rateCoupon RateThe coupon rate is the ROI (rate of interest) paid on the bond's face value by the bond's issuers. It determines the repayment amount made by GIS (guaranteed income security). Coupon Rate = Annualized Interest Payment / Par Value of Bond * 100%read more (interest rate) and a maturity date and can be converted into equity shares upon meeting certain conditions or after a certain period, based on the type of convertible debt issued.
- Suppose the value of equity shares of the company remains low or does not offer significant growth. In that case, the bondholder may choose to retain their instrument in the form of debt and redeem it upon maturity.
- Alternatively, if the value of equity goes up significantly, the bondholder may choose to convert his debt into stock.
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Important Terms in Convertible Debt
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1. Coupon Rate – Like a traditional debt instrumentDebt InstrumentDebt instruments provide finance for the company's growth, investments, and future planning and agree to repay the same within the stipulated time. Long-term instruments include debentures, bonds, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans.read more, a convertible debt also requires the issuer to pay interest to the holder periodically. The interest rate may be fixed or floating, depending on the terms of the instrument.
2. Maturity Date – Debts are issued for a particular period. The maturity date is when all the dues payable are paid in full to the holder. In some instruments, the maturity date is when the debts are converted into equity shares. However, in other cases, the holder may choose not to exercise his right of conversion, and the debt instrument would be repaid in full at the maturity date.
3. Conversion Ratio – A conversion ratio specifies the number of equity shares the bondholder receives upon conversion. Simply put, it is the number of equity shares offered by the company per unit of debt. The conversion ratio is pre-determined at the issuance of the convertible debt. For example, a convertible ratio of 10 means that will receive 10 equity shares upon conversion for every unit of debt.
4. Conversion Price – Similar to the conversion ratio, the conversion price is pre-determined when issuance. It is the price per unit of equity stock at the conversion time.
With the following formula, the relationship between the conversion ratio and the price will be understood –
Conversion Price = Value of Convertible Debt/Conversion Ratio.
How Does a Convertible Debt Work?
Example – Mr. X holds convertible bonds to the value of $1,000 (10 bonds of $100 each). The conversion price is $50. The conversion ratio = 20 (1000/50). That means 20 equity shares are offered for each bond held for conversion. The total number of shares Mr. X shall be eligible to upon conversion = 10*20 = 20 shares of $50 each.
In the same scenario, where only the conversion ratio is given, may calculate the conversion price as – 1000/20 = $50.
Effects of the Market Price on the Conversion of Debt
To make a profit on conversion, the market price of the equity shares should be greater than or equal to the conversion price. In such a scenario, the bondholder would be more likely to exercise the option of conversion. Whereas, if the equity shares are trading at a value lesser than the conversion price, the bondholder stands to make a loss and would be more likely to retain the debt interest.
Let us understand this concept by taking Mr. X’s example. The total debt value is $1,000, and the conversion price is $50. When the market price per equity share is $55, the profit that Mr. X stands to make is $5*20 = $100 ($5 per share).
Alternatively, when the market price of the share is $40, then Mr. X stands to make a total loss of $10*20= $200 on the investment ($10 loss per share).
Types of Convertible Debt
Below are the types of convertible debt.
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#1 – Vanilla Convertible Bonds
It is the most common form of convertible debt wherein, at the time of maturity, the bondholder can convert the bond into equity based on the conversion price, ratio, and market price or may choose to redeem the value of the debt.
#2 – Mandatory Convertible Bonds
As the name suggests, the bonds are mandatorily converted into equity shares upon a specified conversion date and rate. This type of debt does not offer any choice to the holder in terms of the conversion of the debt. Repayment towards a debt instrument is two-fold – repayment of interest and repayment of principal. In the case of mandatorily convertible debentures, the repayment of the principal takes the form of equity shares rather than cash.
It is a cash saving mechanism employed by the company wherein the available cash is utilized for developmental and expansion purposes instead of debt repayment. The conversion ratio and price are pre-determined at the time of issuance of debt and are priced in such a manner that the holder gets the par value of the stockPar Value Of The StockPar value of shares is the minimum share value determined by the company issuing such shares to the public. Companies will not sell such shares to the public for less than the decided value.read more – no premium, no discount.
#3 – Reversible Convertible Bonds
In the case of reversible convertible bonds, the company has the option to convert the bonds into equity shares or retain them in the form of debt, unlike the vanilla convertible bonds wherein the bondholder has the option to convert.
Advantages
- From the investor’s perspective, convertible debt benefits both debt and equity. The bondholder receives periodic interest payments on the debt and may also enjoy the benefit of capital appreciationCapital AppreciationCapital appreciation refers to an increase in the market value of assets relative to their purchase price over a specified time period. Stocks, land, buildings, fixed assets, and other types of owned property are examples of assets.read more if the company performs well.
- From the company’s perspective, convertible securitiesConvertible SecuritiesConvertible securities are securities or investments (preferred stocks or convertible bonds) that can be easily converted into a different form, such as shares of an entity's common stock, and are typically issued by entities to raise money. In most cases, the entity has complete control over when the conversion occurs.read more are easier to raise funds without diluting the capital structure in the short term.
- This type of financing would be most suitable for small-scale companies and startups to raise funds easily without any dependence on past performance.
Disadvantages
- Considering that there is an option to convert the debt into equity and gain capital appreciation, companies are more likely to offer a lower interest rate (coupon rate) on this type of debt.
- As this type of debt is more complicated in which many variables need to be considered. The average individual investor would be more likely to opt for traditional debt instruments.
Conclusion
Convertible debt is an easier way of raising funds for a company that benefits investors’ debt and equity features. In addition, this type of debt offers more advantages than a traditional debt instrument when invested correctly.
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