CONVERTIBLE BONDS

In finance, a convertible note (or, if it has a maturity of greater than 10 years, a convertible debenture) is a type of bond that the holder can convert into shares of common stock in the issuing company or cash of equal value, at an agreed-upon price. It is a hybrid security with debt- and equity-like features. Although it typically has a coupon rate lower than that of similar, non-convertible debt, the instrument carries additional value through the option to convert the bond to stock, and thereby participate in further growth in the company’s equity value. The investor receives the potential upside of conversion into equity, while protecting downside with cash flow from the coupon payments and the return of principal upon maturity.

From the issuer’s perspective, the key benefit of raising money by selling convertible bonds is a reduced cash interest payment. The advantage for companies issuing convertible bonds is that, if the bonds are converted to stocks, companies’ debt vanishes. However, in exchange for the benefit of reduced interest payments, the value of a shareholder’s equity is reduced due to the stock dilution expected when bondholders convert their bonds into new shares.