Convertible Debt (Definition, Types) | How Does a Convertible Debt Work?

What is a Convertible Debt?

Convertible Debt, also known as Convertible Bond is a type of debt instrument that can be converted into equity shares at a subsequent point in time. It is hybrid security as it contains both debt and equity features and offers added advantages to the holder.

Similar to a regular bond, convertible debt is issued by the company with a coupon rate (interest rate) and a maturity date. This debt can be converted into equity shares either upon meeting certain conditions or upon the completion of a certain period of time, based on the type of convertible debt issued.
If the value of equity shares of the company remains low or does not offer significant growth, the bondholder may choose to retain his instrument in the form of debt and redeem it upon maturity.
Alternatively, if the value of equity goes up significantly, then the bondholder may choose to convert his debt into stock.

Important Terms in Convertible Debt

Coupon Rate – Similar to a regular debt instrument, a convertible debt also requires the issuer to pay interest periodically to the holder. The interest rate may be fixed or floating depending on the terms of the instrument.
Maturity Date – Debts are issued for particular periods of time. The maturity date is the date at which all the dues payable are paid in full to the holder. In some instruments, the maturity date is considered to be the date at which 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.
Conversion Ratio – A conversion ratio specifies the number of equity shares that the bondholder would receive 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 time of issuance of the convertible debt. For example – a convertible ratio of 10 means that for every unit of debt, ten equity shares will be received upon conversion.
Conversion Price – Similar to the conversion ratio, the conversion price is also pre-determined at the time of issuance. This is the price per unit of equity stock at the time of conversion.

The relationship between conversion ratio and price can be understood with the following formula –

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 for each bond held, 20 equity shares are offered 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, the conversion price may be calculated as – 1000/20 = $50.

Effects of the Market Price on the Conversion of Debt

In order 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 taking Mr. X’s example. The total debt value is $1000 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 dollar 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.

#1 – Vanilla Convertible Bonds

This is the most common form of convertible debt wherein at the time of maturity the bondholder has the option to convert the bond into equity based on the conversion price, ratio and the market price or alternatively 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 twofold – 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.

This is a cash saving mechanism employed by the company wherein the available cash is utilized for developmental and expansion purposes as opposed to debt repayment. The conversion ratio and price are pre-determined at the time of issuance of debt and are priced in such a manner so as to ensure that the holder gets the par value of the stock – 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 it 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 offers the benefit of both debt and equity. The bondholder receives periodical interest payments on the debt and may also enjoy the benefit of capital appreciation if the company performs well.
From the company’s perspective, convertible securities are an easier way 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 rate of interest (coupon rate) on this type of debt.
As this type of debt is more complicated in which lots of variables need to be taken into consideration, the average individual investor would be more likely to opt for regular debt instruments.

Conclusion

Convertible debt is an easier way of raising funds for a company that offers the benefit of both debt and equity features to the investors. When invested correctly, this type of debt offers more advantages as compared to a regular debt instrument.