Flexibility and Value in Convertibles

There are no cars involved when discussing financial convertibles. This is a type of hybrid bond that permits the owner to convert it into common stock or cash at a previously agreed upon price. This offers specific advantages to both seller and buyer.

The issuer gains because they can raise money with a reduced cash interest payment. If the bonds are converted to stocks later one, the debt disappears. Unfortunately, as the holders convert to stocks, the value of said stocks can drop in value as a result of dilution. The number of investors making the conversion at any given time can vary, and the fear for the issuer is that a large scale conversion would take place over a short period of time.

Putting out convertible bonds lets a company minimize a negative perception of corporate actions. Once a company has gone public, the choice to issue stock is often seen as a sign that the share price is too high. By issuing convertible bonds, the company avoids the negative interpretation. This still allows those holding the bonds to convert to equity if the company does well in the future.

In some ways purchasing convertible bonds can be a calculated gamble. There may be a specific price set at which investors must sell their bonds, or conversely a point until which they cannot sell. Nevertheless these bonds have the advantage of a hidden stock option attached. While initially they offer a lower rate of return, they have the potential for much greater profit assuming things work out well.

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