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Flexibility and Value in Convertibles

There are no cars involved when discussing financial convertibles [1]. This is a type of hybrid bond [2] that permits the owner to convert it into common stock [3] 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 [2] are converted to stocks later one, the debt [4] 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 [5] 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 [6] assuming things work out well.