 Good day, fellow investors. In today's video, we're going to discuss what are convertible bonds, why do companies issue convertible bonds, why do investors buy convertible bonds, what do you need to know about convertible bonds? As an investor, we are going to go to three through three examples of convertible bonds from Tesla, C-Trip and 51 Jobs. And then we're going to see also a bit of accounting how do convertible bonds skew earnings, earnings reported earnings and investment ratios. So that's something also you have to watch. And also you have to watch about dilution. And then at the end, we're going to give a conclusion from an investing perspective, what do you have to remember when you come across convertible bonds? Let's start. A convertible bond is a debt instrument issued by a company in order to get financing as with any other bond. The company will pay a periodic interest rate on the borrowed amount and like any other bond, the bond has a maturity date. But unlike other bonds, the holder of the bond at the end or before the bond matures can exchange that bond for a preset number of stocks at a conversion rate. Below the conversion rate, the conversion price, then it's not worth to exchange the bonds and it's better to get the money back when the bond matures. If the stock price of the company issuing those bonds goes above the conversion price, it's better to convert the bonds into the number of stocks and then sell the stocks or hold to the stocks or do whatever you want with the stocks. So the benefits are there for the investors because he has limited downside because the company will have to repay the principal and he has higher potential upside if the stock price of the entity issuing the bonds goes up. Why does the company issue those bonds? Because a better risk reward profile for the investor means that the interest rate must be much lower than what would it be if the company would borrow into capital markets and issue regular bonds. So there is a lower interest rate and there is even the chance that if the investor converts the bonds into stocks, the company doesn't have to issue cash to repay the investor, but it issues only stocks, which is not a cash expense. Let's start with an example of Tesla's convertible bonds. But before that, just to mention, said Claremants bought post-group acquired 250 million of Tesla convertible bonds during the first two quarters of 2018. Soros bought them too. So let's take a look at what Tesla's bond is and explain why the company issued the bonds and why Claremants and Soros have bought them. Just a normal bond, there is the name, the country, the issuer, the currency, the issue price, the issue date, the coupon, which is 2.375% much lower than the normal coupon, which was about 5.8% when this bond was issued for Tesla. The maturity date and if you look into the second filing for the bond, you can also see the conversion price. So the conversion price is approximately $227 per share of common stock, which means that the holder of $1,000 of a bond of $1,000 can share, can convert the bond at the maturity for 3.05 shares of Tesla. In the meantime, up to the maturity or the conversion date, he will get the 2.375% yield on the invested principle. If you look at this bond, the Tesla 2020 convertible bond stock price, when Tesla's stock price was above the conversion price of $327, you can see also how the bond price increased. However, now the stock is trading below $327, and that's why the bond has a normal yield of I think 0.8%, so the price is around $105. Vesters that are buying Tesla's bond now are getting a yield of 1% to maturity, and in 2022, if Tesla's stock price is below $327, Tesla will repay their principle, repay them with money. So the downside is minimal. If Tesla's stock price is at $700, as some people predict, then they will convert their $1,000 invested into bonds into free 3.0 something Tesla shares, which will be worth $2,000. So by buying a convertible bond, you are open to the upside if the stock price increases, and you have limited downside because the company will repay you the principle plus you get a yield on it. If the company doesn't go bankrupt, then you don't see anything because that's normal with bonds. Why did Tesla issue such a convertible bond? Well, if you compare the current yields on the convertible bond to 0.8, 3.09% with the current yield on the normal bond, 8.6% or the coupon at issued date, so the convertible bonds were issued at 0.25% yield, 1.25% while the normal bond was issued at 5.3%. If you put that into perspective, just on a money perspective, the difference between the 5.3% coupon and the 2.25% coupon that we discussed in the 2020 Tesla bond is about $29 million in interest payment savings in a year. So that's the benefit for the company. Lower interest savings, $40 million per year, over five years is $150 million for Tesla, so that's a big saving. Plus if the shareholders, if the bondholders convert the bond, then the company saves on refinancing because they simply issue stocks as they have been doing all the time. Now, as for convertible bonds and investors, there are two things you have to watch. The first thing is dilution and the second thing is how those convertible bonds, if they go above the strike price, how they skew earnings. Let's look at C-Trips example for convertible bonds to see about dilutions and then we'll go to another Chinese company, 51 Jobs, to see about how that skews earnings. For example, C-Trips total amount of outstanding convertible bonds at the end of 2017 was 4.3 billion. The conversion rates range is from 9 ADS stocks per $1,000 of principal to 15 ADS per $1,000 principal, where the conversion prices range from 40 to 108. With 528 million ADS stocks outstanding, the potential dilution at an average of 12 ADS issued per $1,000 of principal with the convertible bonds is 51.6 million ADSs. That's about 10% of the current number of stocks. When you add the 7% dilution already calculated into the annual report coming from stock compensation data, option plans, and whatever, if things go well and C-Trips stocks goes above the conversion prices of 40 and 108, you can expect additional dilution of 17%. Which is of course not a problem if the stock hits 108 every shareholder would be happy, but it is a burden to think about. Another burden to think about if the company doesn't hit 108 and the stock price is depressed below the first conversion price of 40, then the company will have to refinance 4 billion in convertible bonds, which is a burden on with a company that has a C-Trip just 4 billion in revenue. So that's a pretty big refinancing issue over the next few years. So if things go good, then people forget about the dilution and everything about convertible bonds. If things go bad, then the convertible bonds become really a big weight on the company because the company will have to refinance because nobody's going to convert their bonds into shares if the share price is below the conversion price. The second thing to watch is that convertible bonds depends on how the company accounts them, but if you use GAP earning, GAP accounting, then you account for them even if Tesla doesn't account for that. I didn't dig deep into Tesla's business account, but perhaps the bonds were trading below the conversion price. If the bonds are trading above the conversion price, it means that the company will have to issue stocks and you can issue stocks, you can get cash for that, but in this case they will just repay the principal, but the principal is fixed and the value of the stocks that they will issue is much higher. That difference affects the bottom line of a company negatively, which means there is a loss and that loss goes into the financial reporting. However, that's not a cash expense. They would have issued the stocks even at zero or do some issuing stock is not a business expense, so the earnings get adjusted. However, you might see a price earnings ratio negative, a loss where the operating adjusted earnings are positive and the price earnings ratio is different. Let's look at the 51 jobs come example. So, you can see here how the stock price increased significantly from 60 to 110 during the first two quarters of 2018. And then if we look at the first line number one here, the GAP income, reported income was 43 million US dollars loss, the third column on the right. However, when you add back the change in fair value of convertible senior nodes because the stock price went above the conversion price and the company expects to issue stocks, thus dilute earnings, then you have to add a change in value of 135 million and then the normal GAP adjusted net income is 90 million. So, from a loss of just below one dollar per share, the earnings are now positive at 1.49 per share. So, if you look at those earnings, you would see a loss in your stock screener. If you don't have a sophisticated stock screener, you would see a loss while on the right side, there is a gain just because the stock price exploded and what the company will have to pay in equity, always the same number of shares, always the same dilution, but it affects negatively the stock price. So, that's just a little bit accounting that you have to think about and look at the adjusted earnings, not at the reported earnings. So, to sum up here, with convertible bonds, you have to look at the potential dilution. I remember some shady Chinese stocks that I have been researching in the past, they had 100% dilution if the stock price goes above that conversion price. So, that's something crazy and to think about and often these convertible bonds don't really allow the stock price to go above that because then it leads to significant dilution. If not, it leads to significant repayments for the company. So, those things are long-term, but when you're investing for the long-term, you have to watch that. Secondly, if you can buy convertible bonds, you might do that on the chip. So, if you're a long Tesla, buy convertible bonds. You have the upside, but you have limited your downside just in case, not even if Tesla goes bankrupt, but if the stock price goes down, you don't care. Tesla will repay the principle. If the stock price goes up, you have the right on three stocks, 3.2 stocks. So, buy convertible bonds if you're a long Tesla. Also, those convertible bonds skew earnings. So, that's something to keep in mind when investigating when researching stocks. Thank you for watching. If you like this Accounting for Investor course, please drop me an email and say I want to subscribe for the Accounting for Investing course that I plan to do in the next few months. If you drop me an email, you will get a discount on the starting price and you will be notified when I launch the course. Thank you for watching. Looking forward to your comments and I'll see you in the next video.