When do companies issue convertible bonds

The convertible security financing arrangements might also include caps or other provisions to limit dilution the reduction in earnings per share and proportional ownership that occurs when, for example, holders of convertible securities convert those securities into common stock. By contrast, in less conventional convertible security financings, the conversion ratio may be based on fluctuating market prices to determine the number of shares of common stock to be issued on conversion.

A market price based conversion formula protects the holders of the convertibles against price declines, while subjecting both the company and the holders of its common stock to certain risks. Because a market price based conversion formula can lead to dramatic stock price reductions and corresponding negative effects on both the company and its shareholders, convertible security financings with market price based conversion ratios have colloquially been called "floorless", "toxic," "death spiral," and "ratchet" convertibles.

Both investors and companies should understand that market price based convertible security deals can affect the company and possibly lower the value of its securities. Here's how these deals tend to work and the risks they pose:. Before you decide to invest in a company, you should find out what types of financings the company has engaged in - including convertible security deals - and make sure that you understand the effects those financings might have on the company and the value of its securities.

Even if the company sells convertible securities in a private, unregistered transaction or "private placement" , the company and the purchaser normally agree that the company will register the underlying common stock for the purchaser's resale prior to conversion.

You'll also find disclosures about these and other financings in the company's annual and quarterly reports on Forms K and Q, respectively, and in any interim reports on Form 8-K that announce the financing transaction. If the company has engaged in convertible security financings, be sure to ascertain the nature of the convertible financing arrangement - fixed versus market price based conversion ratios.

Convertibles offer greater potential for appreciation than ordinary corporate bonds and the investor can convert to benefit from stock price gains. In a fixed income portfolio, convertibles can enhance returns through exposure to equity-driven price increases and reduce impact of rising interest rates.

In an equity portfolio, convertible bonds can help reduce downside risk without foregoing all upside potential. Pre-conversion, investors have some protection against default since bondholders are paid before stockholders. Disadvantages of Convertible Bonds Convertible bonds are callable, meaning that the issuer can force investors to convert.

A bond may be issued with a specified call date or the company may call the bond and force conversion if the stock price rises beyond a particular point. Therefore, the upside potential of the investment may be limited.

Convertible bonds are highly correlated to equity markets, meaning their values may be more associated with movements in the stock market than other types of bonds.

Convertibles are sensitive to rising interest rates, although to a lesser degree than plain old corporate bonds. Convertible bondholders are paid a lower coupon rate than corporate bondholders. If many convertible bondholders exercise the conversion option, dilution may occur with attendant negative effects on stock price. Companies that issue convertibles may have weaker credit ratings Convertible bonds are of lower priority than straight bonds in the event of default and are unsecured, meaning if a company goes bankrupt, you may not be repaid the amount you lent them.

How to Buy Convertible Bonds There are several ways to invest in convertible bonds. Should You Buy Convertible Bonds? Was this article helpful?

Share your feedback. Send feedback to the editorial team. Rate this Article. Thank You for your feedback! Something went wrong. Please try again later. Best Ofs. More from. By Kat Tretina Contributor. So how can a company identify the right time to issue a convertible? And what are the elements that make for a good opportunity in this market? The second are the convertible arbitrage funds, which buy convertibles based more on technical factors, and which actively hedge the share price exposure and possibly the credit exposure as well.

These two groups are currently of similar importance and size. The box [Investor considerations when buying convertibles] provides a rundown of the features each group cares about when looking at a convertible.

But can this really be correct? Such an issuer would meet many of the criteria desired by a convertible arbitrage fund, but would probably pay a very low coupon, and also insist on a high conversion premium the amount by which the conversion price exceeds the stock price when the bonds are issued.

In practice, we see that the convertible market is frequently used by small- to mid-cap issuers, often those who have less access to other bond markets and may be unrated. Convertible Bond Numbers. The Bottom Line.

Key Takeaways Convertible bonds are corporate bonds that can be exchanged for common stock in the issuing company. Companies issue convertible bonds to lower the coupon rate on debt and to delay dilution. A bond's conversion ratio determines how many shares an investor will get for it.

Companies can force conversion of the bonds if the stock price is higher than if the bond were to be redeemed. A vanilla convertible bond allows the investor to hold it until maturity or convert it to stock. Article Sources. Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts.

We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy. Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation.

This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace. Related Articles. Convertible Notes How is convertible bond valuation different than traditional bond valuation? Stocks Preferred Stocks vs. Bonds: What's the Difference? Partner Links. Hung convertibles are convertible securities with share prices trading well below the conversion price, making conversion to common stock unlikely.

Fully Convertible Debenture FCD A fully convertible debenture is a debt security in which the whole value of the debenture is convertible into equity shares at the issuer's notice. Convertible Security A convertible security is an investment that can be changed into another form, such as convertible preferred stock that converts to common stock.

Embedded Option An embedded option is a component of a financial security that gives the issuer or the holder the right to take a specified action in the future.