In a market economy, open competition, accelerated modernization of equipment and technologies, it is becoming increasingly difficult for commercial enterprises to stay afloat and increase their momentum towards intensive development. Investment activity is one of the tools that can significantly contribute to this. In turn, investment activities have their own tools. According to experts and analysts, they have completely different efficiencies and the risks associated with it. The purpose of this article is to disclose the concept of convertible bonds as one of the instruments of investment activity, to understand their goals, types, and to understand in detail what advantages exist from their use and what risks this entails.
Convertible bonds. What it is?
To make it easier to understand the essence of this phrase, you need to remember what a bond and conversion are.
A bond is, first of all, a security that reflects the issuer's debt obligation and allows its holder to receive a known income with an initially agreed periodicity during the period of ownership, and then return it to the issuer within a certain period of time, having received his investment back.
Issuer - an enterprise that issued a bond with the expectation of attracting borrowed funds from investors.
The owner of the bond is the investor.
For example, an enterprise produces products that are in demand in the current period, has certain competitive advantages, but according to analysts, in the near future, an enterprise may lose its position due to the use of outdated equipment that will not allow them to increase production with a predicted increase in demand for these products. Equipment modernization is needed, but there is no money. There are many options for raising money, one of them is issuing bonds. That is, the company attracts money from investors and gives them a document on its debt obligation. This document contains all transaction parameters. During the validity period of the debt obligation, the investor receives income on it (the issuer pays interest for using the investor’s money), and at the end of the agreed period, the issuer returns the money to the investor and takes back the debt obligation (bond). If agreed upon by the transaction, the investor may resell the bond to another investor and receive money at the market value of the debt ahead of schedule.
Conversion is a conversion. If we are talking about securities, then this is a transformation or exchange of one type for another. For example, the exchange of shares for bonds, and vice versa.
Hence it is very easy to define convertible bonds. These are ordinary bonds, which include an additional option - an exchange for the shares of this issuer at a specific time.
That is, ordinary bonds can only be returned to the issuer at the end of the term in exchange for their money, while earning income during their ownership, or resold ahead of schedule to other investors.
Convertible bonds give the right, in addition, to exchange them for the issuer's shares at the agreed time intervals. That is, the investor has the opportunity to choose one of the options - use them as ordinary bonds or exchange them for shares.
Main settings
Any security, like any transaction, has parameters (conditions). Key parameters of convertible bonds:
- Nominal value (this is its value at the time of purchase from the issuer). That is, the nominal value of bonds is equal in aggregate to the amount that the investor lent to the issuer, and the issuer will have to return it to the investor at the end of the bond validity period.
- Market price. The value of bonds may vary depending on the growth and development of the enterprise and the demand for securities of this issuer from other investors. At different periods, it can be higher or lower than the nominal. Typically, fluctuations are up to 20%. At market value, bonds can be sold by another investor, but return to the issuer only at face value.
- Coupon rate. This is the interest rate on borrowed funds that the bond issuer pays to the investor.
- The frequency of coupon payments is the interval of interest payments for the use of borrowed funds (every month, once a quarter, once every six months or annually).
- Maturity is the term of a bond. That is, the period for which the investor gives the issuer money in debt. Maybe 1 year, and even 30 years.
- The conversion date is the date on which it is possible to exchange for shares. One end date is possible, either a period in which to do this, or several fixed dates.
- Conversion ratio - shows how many bonds with a certain face value are needed to get one share.
The main types
Before issuing convertible bonds, the company conducts an in-depth analysis based on the objectives of their issue, the market situation, the timing of raising money, targeting a certain circle of investors, etc. Based on this, the conditions that it can lay in the bonds are determined by observing two parameters - maximum benefit for yourself and attractiveness for the investor. Therefore, there are many varieties of convertible bonds. Below are some of them:
- With a zero coupon. This means that interest income on them is not provided, but such bonds are initially sold at a discount (that is, they are sold at a price below par value, but are returned at par). This difference is the discount, which is the fixed income of the investor.
- With the ability to exchange. These bonds can be exchanged not only for shares of the issuer issuing them, but also for shares of another issuing company.
- With obligatory conversion. The investor must make mandatory conversion to shares during the circulation of this bond, there is no choice to sell or exchange.
- With a warrant. That is, a bond is bought immediately with the right to buy a fixed number of shares at a fixed price, which is immediately higher than their market value at the time of purchase. But the coupon rate of the convertible bond will be lower. There are certain risks, but if the issuer company prospers, the investor will exchange the shares in a certain period for shares at a fixed price, which at that time will be lower than the market price. This will be the compensation for the lost interest on the coupon.
- With built-in options. The calculation of convertible bonds with an option gives the investor an additional large discount, but mainly if the circulation period is long (at least 15 years). The investor has the right to demand early repayment of debt obligations (the date of possible repayment is agreed upon at the time of purchase and may be more than one).
The use of convertible shares and bonds as an investment tool has several advantages, both for the issuing company and for the investor. However, there are a number of risks for both parties to the transaction. Below are some of them.
Benefits of use for the issuer
- Attracting borrowed funds through the issuance of bonds is cheaper than raising credit, since the coupon rate is much lower than the interest on the loan.
- The issue of convertible bonds may allow the company to attract significantly greater resources.
- A bond issue is much cheaper than a stock issue. The possibility of converting into shares makes it possible to issue additional shares with the possibility of saving on this process with a delay in the period.
- For issuing bonds, the minimum requirements apply to the company, unlike, for example, the bank’s assessment when issuing a loan. However, a credit rating of a company's reliability is important.
- After conversion, equity is growing, and long-term debt is decreasing.
Benefits of using for an investor
- Investing in cash, having a guaranteed fixed rate of return and the ability to get the issuer's shares at a price lower than the market (this is beneficial in the case of a successful company). If the price of the company's shares falls at the time of conversion, the investor has the right to refuse to convert and use the convertible bond as a simple bond. In this case, the investor is more flexible in deciding to get more profit.
- With the growth of the market value of the issuer's shares, the price of bonds also increases. This makes it possible to obtain additional profit, while the right to convert has not been realized.
Risks to the issuer
- An enterprise always has a risk of financial difficulties, which can complicate the servicing of debt obligations.
- Problems may arise when planning activities, despite the fact that the issuer makes various possible forecasts when issuing convertible bonds. This is a consequence of the fact that only an investor, not an issuer, decides to convert or pay off a debt obligation.
Risks for the investor
- If a mass conversion begins, liquidity decreases significantly, this will complicate trading in the securities market, which means there is a risk of loss of potential profit.
- Lower yield compared to ordinary debt securities. If the stock price remains unchanged or falls, the investor will refuse to convert and will not receive the expected profit.
Use in Russia
The experience of using convertible bonds in Russia is not as great as in Western countries and the USA. However, large companies resort to this method of borrowing. The most common bond maturity is five years. Although it can be from 1 to 5 years. As a rule, the nominal value of a bond is 1,000 rubles.
Large companies with high credit ratings can issue these bonds with an aggregate nominal value of up to $ 1.5 billion. Smaller companies can raise up to $ 500 million.
Mainly bonds with mandatory conversion are used, which allows the issuer to significantly reduce the yield on the coupon, or even eliminate it.
Output
In essence, a convertible bond consists of an ordinary bond and an additional option of free exchange for a predetermined number of ordinary shares at a fixed price. Such a bonus, in turn, reduces the interest on the coupon of such a bond, unlike a regular bond. This method of borrowing is widely used both in Russia and abroad, as it provides a number of advantages for both issuing enterprises and potential investors. However, not all types of these bonds are currently used in Russia.