What are convertible debt securities?

1. Nature of convertible debt securities

Convertible debt securities are a type of hybrid investment instrument that can be exchanged for another type of security.

This exchange can be executed by either the investor or the issuer of the convertible debt security. The convertible debt security typically has features of both debt and equity instruments. One of the most frequently used forms of convertible debt securities involves the issuance of bonds by a company that can be exchanged for shares of common stock. The terms of the conversion between bonds to equities are determined at the time of the bond issuance. Investors and issuers are aware of the agreed upon price at which the debt securities can be swapped for stock at the time the convertible debt securities are issued.

Why invest in convertible debt securities?

An investor in convertible debt securities has an unlimited upside potential if the stock of the company appreciates. The investor is able to convert their bonds to equities and participate in any upside of stock prices. The potential upside is a strong incentive to invest in convertible debt securities. Investors in convertible debt securities are able to collect interest payments, also called coupon payments, as long as the instrument is held in its bond form. These payments limit the downside risk of the investment by providing an investor with a flow of predetermined cash payments.

Why issue convertible debt securities?

Corporations that issue convertible debt securities are using a relatively low cost means to raise capital. The coupon payments for convertible debt securities are relatively low, which is an upside for the corporation. The downside is the potential dilution in stock shares that the corporation faces if the investors in their convertible debt securities elect to convert the shares of convertible debt bonds to shares of the corporation's equity.

What is the typical structure of a convertible debt security?

Similar to standard bonds, the convertible debt security will have a face value, issue size, date, maturity date, value, and interest rate. Unlike typical bonds the convertible debt security will have a predetermined conversion price. When the value of a company's stock hits the conversion or predetermined share price either the issuer or the investor has the option to exercise the conversion. When the conversion is exercised, the convertible debt security is exchanged for securities at the conversion price at the predetermined conversion ratio. The conversion ratio is another factor that is determined at the issuance of the convertible debt security.

For example, suppose a company issues a convertible bond at a par value of $10,000. According to the issuance documents, the investor in the convertible bond can convert it to common stock of the company at a price of $25 per share (i.e. conversion price). By dividing the par value of the bond by the conversion price, it's possible to determine that if converted, the bond will result in 400 shares of the company (i.e., $10,000 ÷ $25 = 400 shares).

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