Public companies issue corporate bonds all the time, but not all bonds are the same. A convertible bond is one that you can convert into shares of stock at your discretion. This means that you'll be able to take advantage when the company's share price increases, as standard bondholders receive only interest payments as creditors of the company while, as a shareholder, you can potentially make a profit off the appreciation.
A company has several choices to finance its operations. It can use its own cash, issue shares to investors, borrow the money from a bank or borrow the money by issuing corporate bonds. A convertible bond is a hybrid security that appears on the company's balance sheet as debt but allows the bondholder to convert his bonds into shares any time before maturity. Because of this feature, a convertible bond sells at a premium to a standard corporate bond. Companies prefer to issue convertible bonds because bondholders are willing to accept lower interest rates.
A company's balance sheet shows a company's net worth at a point in time as reflected in the difference between the company's assets and liabilities. Short-term assets represent items that are highly liquid or close to cash such as accounts receivable. Long-term assets represent items such as plant and equipment. Short-term liabilities are borrowings due in one year or less such as accounts payable and revolving credit. Because convertible bonds have a maturity of greater than one year, they appear under the long-term liabilities section of the balance sheet.
How Convertible Bonds Work
Convertible bonds are issued in face amounts of $1,000 with maturity dates of 10 to 20 years. As with a standard bond, bondholders receive interest payments twice a year. The owner can choose to convert the bond at any time before the bond matures. A convertible bond has a conversion ratio, which is how many shares a bondholder can expect to receive when he converts the bond. For example, a bond with a conversion ratio of 50 has a conversion ratio of $1,000 divided by 50 or $20 per share. The equity value of the bond is how much the shares would be worth if the bonds converted at current market values. For example, if the shares currently trade for $15 per share, the equity value of the convertible bond is $750 ($15 x 50).
Balance Sheet Impact
Issuance of a convertible bond, like any other bond, increases the company's long-term liabilities. This increases the financial risk of the company, particularly from the perspective of non-convertible debt holders, other creditors and shareholders. Remember, even though there is a chance the bond may be converted into equity, the company must still make regular interest payments to bondholders. In addition, a convertible bond has the potential of diluting shareholders' equity. When a bondholder converts his bond into shares, the company must spread its profits across more shares, meaning each shareholder takes a smaller piece of the pie.
Analysts like to consider events that may affect a company and the likely impact on the company's financial outlook, such as when a company issues convertible bonds. Share price is a key determining factor when considering the impact of convertible bonds. For example, if the shares are trading at $10, and a convertible bond converts to $30 per share, a convertible bondholder has no incentive to convert his bond. For all intents and purposes, analysts treat the convertible bond as straight debt. However, if the share price rises above $30, it's highly likely that the bonds will convert to equity. In this case, the analyst must make adjustments to debt and shareholders' equity to factor the impact if all the bonds covert, whether this happens or not. This increases the company's share count, which is not too pleasing for existing shareholders. Earnings per share decline as a result. The conversion affects debt-based ratios such as debt-to-equity. Equity-based ratios like return on equity are affected as well.
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