Advantages & Disadvantages of Convertible Debt

Convertible debt can be a useful investment option.
i Hemera Technologies/ Images

For couples seeking new ways to invest their money, convertible debt can provide an attractive opportunity to invest in a new company. By investing in debt, you are basically lending money to a company. This provides you with greater investment protection if the company goes out of business, since you will be considered a creditor instead of an owner. If the company succeeds, you have the option of converting the debt into shares of stock. However, by investing in convertible debt, you are not able to set a price for the company’s stock ahead of time, which creates risk.

Investment Protection

An example of a type of convertible debt is a bond that pays you interest on your bond purchase and has the additional option of converting your investment into company stock by a certain date or based on a future event. Since you are initially investing in a debt, your investment has greater protection from loss due to your creditor status. If the company goes out of business, creditors are paid before stock investors.

Benefits of Conversion

A convertible debt instrument provides benefits found in both debt and stock investments. For example, let’s assume you decide to invest in a risky new venture by purchasing a convertible bond with stock warrants. The bond agreement should contain the details of how the conversion of the bond into the shares granted by the warrants will take place. Since the conversion takes place at a future date, you have more time to decide whether to convert the debt into stock or keep the bond investment. The issuance of convertible debt also costs less in transaction costs than a stock sale -- you can invest more quickly and easily in a new business, while also having the option to acquire stock in the future.

Company Valuation

The issuance of convertible debt provides a benefit to the business, which can avoid the tedious task of coming up with an initial value for the company that may not match the market price. If you purchase convertible debt that automatically converts into stock at the current market price, you may end up acquiring shares valued at a higher market price than if you had initially purchased stock. The higher price paid for the shares can decrease your profit amount when you sell the stock.

Investment Risk Vs. Return

By investing in convertible debt, an investor provides funds to a business whose value is not yet known. This fact can greatly increase your risk, especially if the debt automatically converts to stock at a future date. If the business is not successful, you can lose the protection provided by the debt investment once the conversion to stock takes place. Your rate of return earned as a debt investor may not be high enough to reward the amount of risk you will take on as a future stock investor in the company.

the nest