The fixed-income security market is mostly composed of financial instruments which offer a fixed stream of income to investors.

In other words, this means that the possible downside that investors may face is protected while at the same time investors can have only a limited upside. This is exactly opposed to stocks wherein the possible downside which is unlimited whereas the upside could also be unlimited. Convertible debt is a complex financial product that tries to provide investors with the best of both worlds. This means that convertible debts are a financial product that offers investors limited downside and an unlimited upside opportunity at the same time.

In this article, we will have a closer look at how convertible bonds work. The details have been mentioned in the article below.

How Convertible Bonds Work?

Convertible bonds are financial instruments that start off as bonds in the initial years of the investment. However, with the passage of time, investors are given the option to convert their bonds to equity shares from time to time. The ratio at which this conversion will happen is already predetermined and mentioned in the covenants of the bond. The details of the working of convertible debt have been explained below.

• An investor invests an initial amount that is taken on by the borrowing company as debt. This means that the borrowing company will pay periodic interest to the bondholder.

• These coupon payments might continue for a certain amount of time. However, after some time has elapsed (let’s say a year), the investor will be given an option to either continue receiving coupon payments on convert the outstanding bond into an equity share.

• Based on the covenants mentioned in the bond indenture, this option can be given multiple times during the life of the bond.

• At this stage, investors typically compare the market price of the debt that they hold with the price of the equity which has been pre-decided and mentioned in the bond indenture. It is important to know that the market price of equity is not relevant to them and it is the contract price that would accrue to them if they were to exercise the conversion option.

• Hence, based on the investor’s decision, the debt will either have to be paid off or it can simply be extinguished. If the debt is indeed extinguished, then bond investors end up in possession of equity shares. These equity shares are the same as regular equity shares. They give the investors the right to obtain dividends and exercise voting rights just like other shareholders.

Important Terms Related to Convertible Debt

Convertible debt is a complex financial instrument. Hence, in order to make an informed financial decision, investors need to be more financially aware of certain terms. The terms which are most commonly used in the indenture of a convertible debt have been mentioned below:

• Conversion Ratio: The conversion ratio is the ratio between the number of bonds and the number of equity shares. This ratio is mentioned in the indenture of the original bond. For example, the indenture may explicitly mention that one bond may be exchanged for four shares.

• Conversion Price: Conversion price is the predetermined price that is mentioned in the bond indenture for conversion of debt to equity. This price is arrived at by dividing the value of the bond by the conversion ratio. For instance, if the bond price is $100 on the day of conversion and the ratio is four, then the implied conversion price is $25.

• Conversion Value: Conversion value is the financial value of the shares which are received after conversion. For instance, if the contract states that four shares have to be issued for every bond, then a $100 bond would be replaced with four shares. However, after new shares are handed over to the investors, they can immediately sell them at the market price. Let’s assume that the market price of each share is $35. In such cases, the conversion value would be $100.

• Conversion Premium: Conversion premium is the extra amount of money that is paid by the borrower in order to allow the lender to convert their debt into equity. In the above example, if the company had paid back the debt, they would have paid $100 to the investors. However, since the debt is converted to equity, they paid an equivalent of $140 to the investor. In essence, they have paid an additional $40 to the investors. These additional $40 are referred to as the conversion premium.

• Conversion Parity: Conversion parity is another important term used in bond indentures. Conversion parity is the ratio at which the market value of the bond would be equal to the market price of the shares. For instance, in this case, the bond value is $100 and the value per share is $35. Hence the conversion parity would be $100/$35 i.e. 2.86. It is common for bond indentures to have covenants that reduce the conversion ratio after the parity has been reached. Hence, it is important for investors to be aware of this concept.

The fact of the matter is that convertible debt is an extremely versatile form of financial instrument which are used by investors and corporations worldwide. However, they are more complex than regular bonds. Hence, unless an investor has the specific know-how as to how to evaluate such bonds, they should be exercise caution while investing in them.