Management Notes

Reference Notes for Management

What are Convertible Bonds?

What are Convertible Bonds?

  1. Fixed-income instruments, usually issued by high-rated companies in the form of a public issue to accumulate long-term capital appreciation.
  2. The financial security cannot be redeemed early by the issuer except with the payment of a penalty.
  3. Bonds can be redeemed or paid off by the issuer prior to the bonds’ maturity date.
  4. A fixed-income corporate debt security that yields interest payments.

Answer: d. A fixed-income corporate debt security that yields interest payments

Answer Explanation

To raise capital, companies issue convertible bonds. They are called “convertible” because they can be converted into a predetermined number of the company’s common stock at a specified conversion price. In essence, a convertible bond is a combination of a bond and an equity option. Let’s break down each part of the answer to understand why it is correct.

Fixed income corporate debt security: Convertible bonds are a type of fixed-income corporate debt security issued by corporations to borrow money from investors. When investors purchase convertible bonds, they are lending the company money. The company agrees to pay regular interest payments, usually semi-annually or annually, at a fixed rate, referred to as the coupon rate, for a specified period until the bond matures.

Yields interest payments: The issuing company pays regular interest payments to bondholders based on the face value of the bond and the coupon rate. This interest payment is calculated based on the coupon rate and the face value of the bond. Bondholders receive interest payments until the convertible bond matures, because the coupon rate remains constant throughout its life.

Why the other options are not correct

a. Fixed-income instruments, usually issued by high-rated companies in the form of a public issue to accumulate long-term capital appreciation.

Convertible bonds are indeed fixed-income instruments, but they are not primarily issued for long-term capital appreciation. Convertible bonds are primarily issued to raise capital through debt financing, not for long-term capital appreciation. Moreover, convertible bonds can be issued by companies with high credit ratings, but they are not the only ones who can do so, and companies with different credit ratings can also do so.

b. The financial security cannot be redeemed early by the issuer except with the payment of a penalty.

Due to the fact that it describes a call feature commonly associated with traditional bonds, not convertible bonds, this option is incorrect. It is possible for the issuer to redeem a bond before its maturity date under a call feature, but the issuer would usually have to charge a premium or penalty to bondholders for early redemption.

Unlike call bonds, convertible bonds usually have a conversion feature, where bondholders have the option of converting their bonds into common stock of the issuing company at a predetermined ratio and price.

c. Bonds can be redeemed or paid off by the issuer prior to the bonds’ maturity date.

In this case, the feature described is not applicable to convertible bonds, but to traditional bonds. There may be a maturity date when the issuer is required to repay the bondholders their face value. Convertible bonds, however, have both debt and equity features. A convertible bond is not necessarily redeemed or repaid at maturity by the issuer. If they wish, bondholders can convert their bonds into the issuer’s common stock.

Conclusion

A convertible bond is a fixed-income corporate debt security that pays regular interest to bondholders until it matures. It has the characteristics of both a bond and an equity option. Convertible bonds are distinguished by their conversion feature, which permits bondholders to convert their bonds into a predetermined number of shares at a specified price of common stock of the issuing company. In the event that the company’s stock price rises significantly, investors can benefit from capital appreciation.

Due to the equity component of convertible bonds, companies can raise capital at a lower interest rate than regular bonds, making them a valuable tool for both investors and companies. Investors can benefit from convertible bonds by participating in potential stock price appreciation while still receiving regular interest payments. Before making any investment decision, investors should carefully consider the terms and conditions of the convertible bond and the financial health of the issuing company.

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Bibisha Shiwakoti

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