A convertible bond is a hybrid financial instrument that combines features of both debt and equity. In simpler terms, it's like a bond that can "transform" into shares of the issuing company under specific conditions. The issuer pre-determines the terms under which bondholders can choose to convert their bonds into an equivalent amount of the company's stock at a favorable time. Convertible bonds offer a middle ground for investors uncertain about the issuer's future growth prospects.
Basic conversion conditions for convertible bonds
Conversion Period
Start Time: Generally, no less than six months after the completion of the issuance of convertible bonds.
End Time: Determined by the issuer based on the maturity of the convertible bonds and the company's financial condition, usually before the maturity date of the convertible bonds.
Conversion Price
Determination Method: Set at the time of issuance, generally not lower than the average stock price of the company over the 20 trading days prior to the announcement of the prospectus and the price on the previous trading day.
Adjustment Mechanism: In certain cases, the conversion price may be adjusted due to reasons such as dividend distributions, stock grants, or additional share issuances.
Conversion Quantity
Proportional Relationship: Determined based on the ratio of the face value of the convertible bond to the conversion price, i.e., each bond can be converted into a certain number of shares.
Characteristics of Convertible Bonds
Bond Attributes
Fixed Income: Before conversion, holders of convertible bonds can receive fixed interest income, similar to regular bonds. However, compared to regular bonds, convertible bonds generally offer lower interest rates.
Principal Repayment at Maturity: At maturity, the issuer will repay the principal as agreed.
Credit Risk: Like regular bonds, convertible bonds carry the risk of issuer default.
Stock Attributes
Conversion Right: Under certain conditions, convertible bondholders have the right to convert their bonds into company shares, thereby sharing in the company’s future growth.
Gains from Stock Price Increase: When the company’s stock price rises, the value of the converted stock increases as well.
Dual Benefits: Convertible bond investors can enjoy both the fixed income from the bond and the opportunity to benefit from the stock’s appreciation, offering a balance of "offense and defense."
Forced Redemption: Under specific conditions, the issuer can forcibly redeem the convertible bonds.
Other Clauses: Different convertible bonds may include other special clauses, such as put options or contingency clauses.
Difference between convertible bonds/regular bonds
Nature: Regular bonds are purely debt instruments, with the issuer paying interest periodically and repaying the principal at maturity. Convertible bonds, on the other hand, are a combination of a bond and a stock option.
Returns: The return from regular bonds comes from the fixed interest payments, making them fixed-income securities, whereas convertible bonds offer returns from both fixed interest payments and potential gains from an increase in the stock price.
Risk: The risk of regular bonds is singular, mainly the credit risk, which is the risk of issuer default. Convertible bonds, however, carry both credit risk and market risk, as the stock price may fluctuate.
Price: The price of regular bonds is mainly influenced by interest rates, while the price of convertible bonds is affected by multiple factors, such as interest rates, stock prices, and company performance.
Clause Complexity: Convertible bonds are more complex than regular bonds, with clauses covering conversion price, conversion period, forced redemption, and other aspects.
Advantages of Convertible Bonds
Dual Benefits
Bond Returns: Before conversion, holders of convertible bonds can receive fixed interest payments, similar to regular bonds.
Stock Returns: When the company's stock price rises above the conversion price, investors can convert the bond into shares, participating in the company’s growth and benefiting from stock price appreciation.
Relatively Low Risk
Bond Characteristics: The bond nature of convertible bonds provides principal protection to investors. Even if the company's business deteriorates, investors can still receive partial repayment of the principal.
Limited Downside: The price of a convertible bond typically does not fall below its pure bond value, which is the sum of the bond's principal and interest.
Good Liquidity:Compared to non-listed company bonds, listed convertible bonds offer better liquidity, allowing investors to trade in the secondary market at any time.
Disadvantages of Convertible Bonds
High Complexity：
Convertible bond terms are relatively complex, involving conversion price, conversion period, forced redemption, put options, and other aspects, making it challenging for regular investors to fully understand and manage these clauses.
High Market Volatility:
The price of convertible bonds is influenced by multiple factors such as interest rates, stock prices, and company performance, resulting in significant volatility. When market conditions change, the price of convertible bonds may fluctuate drastically, posing a greater risk to investors.
Information Asymmetry:
Investors may have limited access to relevant information about convertible bonds, which could lead to information asymmetry and result in poor investment decisions.
Liquidity Risk:
Some convertible bonds, especially those from small-cap companies, may have poor liquidity. Investors might struggle to find suitable buyers in the market, making it difficult to liquidate their investments promptly.
Credit Risk:
Although convertible bonds have the characteristics of bonds, the issuer still faces the risk of default. If the issuer's business deteriorates, investors may suffer losses to both principal and interest.
Difficulty in Timing Conversion:
Investors need to time the conversion of bonds to maximize returns. However, it is challenging to pinpoint the best time to convert. Converting too early may cause investors to miss out on further stock price appreciation, while converting too late may result in lost conversion benefits.
Regulatory Policy Change Risk:
Changes in regulatory policies could impact the convertible bond market, so investors need to pay attention to relevant policy changes.
Overall, convertible bonds are a high-risk and high-yield investment tool. Before investing in convertible bonds, investors must be well-prepared to understand the risks and returns and make rational investment decisions based on their own risk tolerance.
