What are the advantages and disadvantages of convertible bonds?

Convertible bonds are a type of debt instrument that can be exchanged for a fixed number of shares of the issuing company's stock at a predetermined price. They are often used by companies to raise capital, lower their borrowing costs, and attract investors who want to benefit from both fixed income and equity exposure. However, convertible bonds also have some drawbacks that both issuers and investors should be aware of. In this article, we will discuss the advantages and disadvantages of convertible bonds from both perspectives.

1 Advantages for issuers

One of the main advantages of issuing convertible bonds is that they can lower the interest rate that the company has to pay compared to regular bonds. This is because the investors accept a lower coupon in exchange for the option to convert their bonds into shares if the stock price rises above a certain level. This way, the company can save on interest expenses and reduce its debt burden. Another advantage is that issuing convertible bonds can avoid diluting the existing shareholders' ownership, as the conversion only happens if the stock price increases. This can also signal confidence in the company's future growth prospects and attract more investors.

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Lucy Morrow

High Value Client Manager at RBC Direct Investing
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In my experience, it's usually the smaller startups that lean towards issuing convertible bonds. Since they often come with lower interest rates, convertible bonds can reduce the immediate financial burden on startups that may not have significant revenue streams yet.

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2 Disadvantages for issuers

On the other hand, issuing convertible bonds also has some disadvantages for the company. One of them is that if the stock price rises significantly, the company may have to issue more shares to honor the conversion option, which can dilute the earnings per share and affect the valuation. Another disadvantage is that issuing convertible bonds can create a conflict of interest between the bondholders and the shareholders, as the bondholders may prefer the company to pursue more risky strategies that increase the stock price, while the shareholders may prefer more conservative policies that protect the cash flow and dividends.

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3 Advantages for investors

For investors, convertible bonds offer a hybrid investment that combines the features of both bonds and stocks. One of the advantages is that they can receive a fixed income stream from the coupon payments, which can provide stability and protection in case of market downturns or volatility. Another advantage is that they can participate in the upside potential of the company's stock, as they have the option to convert their bonds into shares if the stock price appreciates. This way, they can benefit from both scenarios and diversify their portfolio.

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CA Deepak Garg

CA | CPA | EY | Ex-KPMG | Ex-Ministry of Commerce | Management Consultant
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Convertible bonds offer potential advantages for investors as they provide regular interest income and the option to convert into company stock, potentially benefiting from stock price appreciation. However, disadvantages include lower interest rates compared to non-convertible bonds and potential dilution if conversion occurs, impacting existing shareholders. Investors should weigh these factors based on their risk tolerance and investment goals.

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4 Disadvantages for investors

However, convertible bonds also have some disadvantages for investors. One of them is that they usually have a lower coupon rate than regular bonds, which means they sacrifice some current income for the conversion option. Another disadvantage is that they are exposed to the downside risk of the company's stock, as they may lose value if the stock price declines below the conversion price. Moreover, convertible bonds are more complex and less liquid than regular bonds or stocks, which means they may be harder to value, trade, or hedge.

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5 How to evaluate convertible bonds

To evaluate whether a convertible bond is a good investment or not, investors need to consider several factors, such as the coupon rate, the conversion price, the conversion ratio, the maturity date, the credit rating, and the market price of both the bond and the stock. These factors determine the current yield, the yield to maturity, the conversion value, the conversion premium, and the breakeven point of the convertible bond. Investors can use these metrics to compare different convertible bonds and assess their risk-reward profile.

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6 Tips for investing in convertible bonds

If you are interested in investing in convertible bonds, here are some tips to help you make informed decisions. First, you should do your homework and research the company's financial performance, growth prospects, and competitive position. Second, you should analyze the terms and features of the convertible bond, such as the coupon rate, the conversion price, the conversion ratio, the maturity date, and the call or put provisions. Third, you should monitor the market price movements of both the bond and the stock, and be ready to exercise your conversion option or sell your bond if the conditions are favorable. Fourth, you should diversify your portfolio and allocate a reasonable portion of your funds to convertible bonds, depending on your risk appetite and investment goals.

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7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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What are the advantages and disadvantages of convertible bonds?

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1 Advantages for issuers

2 Disadvantages for issuers

3 Advantages for investors

4 Disadvantages for investors

5 How to evaluate convertible bonds

6 Tips for investing in convertible bonds

7 Here’s what else to consider

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