 Personal Finance PowerPoint Presentation, Convertible Bond. Prepare to get financially fit by practicing personal finance. Most of this information can be found at Investopedia Convertible Bond, which you can find online. Take a look at the references, resources, continue your research from there. This by James Chen, updated October 6, 2020. In prior presentations, we've been taking a look at investment goals, investment strategies, investment tools, keeping them in mind. We're now asking, what is a convertible bond? A convertible bond is a fixed income corporate debt security that yields interest payments but can be converted into predetermined number of common stock or equity shares. We've been discussing bonds in general in prior presentations, noting that you could think of it kind of like loaning money to the issuer of the bond. We're on the investment side of things. We expect to have basically a fixed return often times when we're loaning the money. We might first think about the government, government bonds. So we'd be basically giving money to the government in exchange for the government bonds or corporate bonds, giving money to a corporate corporation in exchange for the bond. The bond generally being then kind of like a loan, so they're going to return the money in essence at the end or at the maturity date. And then they're also going to be paying kind of like rent on the money similar to if you were to say rent out an apartment building, you would expect the apartment building back at the end of the rental term plus rent on it, which is equivalent in essence to interest, which would be the rental payment in essence on the loaning of the money. So now we've got the added kind of component of being able to convert the bonds. And this of course would mean that we're talking not about government bonds but about corporate bonds because those are the ones that have that stock basically component to it comparing and contrasting as we saw in prior presentations, investing in common stocks versus investing in the bond. Now we have kind of both worlds involved here, a bond that has this kind of conversion component to it. All right, so the conversion from the bond to stock can be done at certain times during the bond's life and is usually at the discretion of the bond holder. So typically the bond holder has the discretion given the terms of the bond as to whether they want to convert it basically to stock. So as a hybrid security, the price of a convertible bond is especially sensitive to changes in interest rates, the price of the underlying stock and the issuers are credit rating. So the components are factors that we're going to take into consideration when thinking about the value of the convertible bonds now. Interest rates of course, and then the price of the underlying stock, obviously the stock value then we have to think about in terms of whether it would be worthwhile to convert and so on. And the issuers credit rating, meaning how likely is the company basically to be able to continue to pay its obligations in essence in the future. So understanding convertible bonds, convertible bonds are a flexible financing option for companies. A convertible bond offers investors a type of hybrid security which has features of a bond such as interest payments while also providing opportunity of owning the stock. So this bonds conversion ratio determines how many shares of stock you can get from converting one bond. So then of course we got to think about, okay, how are they going to set this up? We could structure this many different ways. If I was to convert the bond, then how many shares would I get? So for example, a five colon one five to one ratio means that one bond would convert to five shares of common stock. So if you convert the bond five shares common stock, the conversion price is the price per share at which the convertible security, such as corporate bonds, or preferred shares can be converted into common stock. The conversion price is set when the conversion ratio is decided for a convertible security. So the conversion price and ratio can be found in the bond indenture in the case of convertible bonds or in the security prospectus in the case of convertible preferred shares. Varieties of convertible bonds. A vanilla convertible bond of playing a general convertible bond provides the investor with the choice to hold the bond until maturity or convert it to stock. If the stock price has decreased since the bonds issued date, the investor can hold the bond until maturity and get paid the face value. So clearly if you bought the convertible bond and then the stock price goes down, you're probably not going to do the conversion because the stock price went down. And therefore you're probably going to hold the bond until maturity. If the stock price increases significantly on the other hand, the investor can convert the bond to stock and either hold or sell the stock at their discretion. So obviously if the stock price goes up, then the conversion feature, the ability to convert becomes more valuable. You're more likely to then do the conversion after converting. You could hold the stock and generate whatever is generated from that, meaning future dividends possibly and the increase in the stock price or you could just sell the stock at that important time for the higher value. So ideally an investor wants to convert the bond to stock with the gain from the stock sale proceeds face value of the bond plus the total amount of remaining interest payments. So mandatory convertible bonds are required to be converted by the investor at a particular conversion ratio and price level. So you get a little bit more complex in the types of convertibility we have here. On the other hand, a reversible convertible bond gives the company the right to convert the bond to equity shares or keep the bond as a fixed income investment until maturity. If the bond is converted, it is done so at a present price and conversion ratio, benefits and disadvantages of convertible bonds. Issuing convertible bonds can help companies minimize negative investor sentiment that would surround equity issuance. Each time a company issues additional shares or equity, it adds to the number of shares outstanding and dilutes existing investor ownership. So if you're looking at the company side of things and they're trying to generate more capital because they're trying to increase a project or something like that, they can either, for example, issue more shares of stock or they can basically issue the bonds. The problem with stock is that you have that ownership component along with the stock. So as you issue more shares of stock, it kind of deludes to some degree, possibly the voting kind of percentage ratio and so on of the current existing stocks out there and possibly the calculation with regards to the earnings per share calculation as well. So like the value of the company distributed over, in essence, you could think of, for example, the owners of the company in terms of the number of shares, the company might issue convertible bonds to avoid negative sentiment. Bond holders can then convert into equity shares should the company perform well. So then as the company does well, then it would be less of an issue basically to have the convertible issue or have the more shares. Issuing convertible bonds can also help provide investors with some security in the event of default. A convertible bond protects investors' principal on the downside but allows them to participate in the upside should the underlying company succeed. So if you have the convertible bond, then it's kind of nice because you could say, well, if I had the stock and the value of the company went down, I would lose. But the convertible bond, you've got that baseline because you should get the bond payments, the interest payments no matter what, even if the stock goes down unless they went bankrupt and didn't pay the bonds back, which hopefully doesn't happen. And then if it goes up, then you can convert and take advantage of the increased value. So you've got the upside and some limit to the downside. So a startup company, for example, might have a project that requires a significant amount of capital resulting in a loss in the near term revenues. However, the project could lead the company to profitability in the future. Convertible bond investors can get back some of their principal upon failure of the company while they can also benefit from capital appreciation by converting the bonds into equity if the company is successful. So if you've got a small company that's got a startup and they're trying to invest and they say, if I build this new plant, if I build this new thing, this piece of equipment, then we're going to have more revenue and the company's value is going to go up. Well, if you have a convertible bond and it doesn't play out that way, as long as they can still pay off the convertible bond, you're kind of locked in on the downside. And if it does go up, you can convert them to stocks and take advantage of the wise investment that they did, the cool business plan. Investors can enjoy the value added component built into convertible bonds, meaning they're essentially a bond with a stock option, particularly a call option. So a call option is an engagement that gives the option buyer the right, not the obligation to buy a stock bond or other instrument at a specified price within a specified period. However, convertible bonds tend to offer a lower coupon rate or rate of return in exchange for the value of the option to convert the bond into common stock. Companies benefit since they can issue debt at lower interest rates than with traditional bond offerings. However, not all companies offer convertible bonds. Also, most convertible bonds are considered to be riskier, more volatile than typical fixed income instruments. So the fact that, I mean, usually we think about the investments when we're investing. We think about, okay, we've got stocks, which are straightforward because they're all standard units of the corporation and they're all kind of the same. That's the point. And then we've got bonds, which are straightforward because we fixed everything up at the beginning and we know what the income stream is going to be. Now you've got this two worlds kind of thing combined into one instrument, which is interesting. But obviously it adds a lot more confusion and variables and components, which can add to more risk and complexity with relation to them. So pros, investors receive fixed rate interest payments with the option to convert to stock and benefit from stock price appreciation. Investors get some default risk security since bondholders are paid before common stockholders. Companies benefit by raising capital without immediately diluting their shares. Companies may pay lower interest rates on their debt compared to using traditional bonds. Cons, due to the option to convert the bond into common stock, they offer a lower coupon rate typically because they've got more cool features to them. So issuing companies with little or no earnings like startups create an additional risk for convertible bond investors. So if you're doing this with smaller companies because you're trying to get the upside without the, you know, without the downside kind of thing, then of course now you're investing in more riskier companies inherently because these are startup companies as opposed to larger companies that are less likely to have liquidity problems in the future if they're a big established company. So share dilution happens if the bonds convert to stock shares, which may depress the shares price and the earnings per share, the EPS dynamics. Example of a convertible bond. As an example, let's say ExxonMobilCorp XOM issue a convertible bond with a $1,000 face value that pays 4% interest. The bond has a maturity of 10 years and a convertible ratio of 100 shares for every convertible bond. If the bond is held until maturity, the investor will be paid $1,000 in principle plus $40 in interest for that year. However, the company shares suddenly spike and are trading at $11 per share. As a result, the 100 shares of stock are worth $1,100, which is 100 shares times $11 share price, which exceeds the value of the bond. So the investor can convert the bond into stock and receive 100 shares, which should be sold in the market for $1,100 in total. So notice if they do the conversion, then they get the shares, which at that point in time would be valued at whatever the market price was. So if you held on to the shares, you'd have that stock price valued at the $1,100. You could hold on to them at that point, possibly getting future dividends, possibly future increases, but being subject to future losses as well. Or you could sell it at that point on the market for the value it's currently valued at.