Are convertible bonds stocks or bonds? Actually, they are essentially corporate bonds that can be converted by the holder into the common stock of the issuing company. Is it wise to invest in convertible bonds? Get to know the pros and cons of this type of investment to weigh better if these securities are for you.
List of Advantages of Convertible Bonds
1. Convertible bondholders receive only a fixed, limited income until conversion.
This is a great advantage for the company because a bigger chunk of the operating income is available to the common stockholders. If a company does well, it has to share its operating income only with the newly converted shareholders.
2. Voting control is in the hands of common stockholders.
Bond holders cannot vote for directors. So if the management level of a company is concerned about losing voting control of the business and need an alternative means of financing, selling convertible bonds will be more advantageous than using common stock for funding.
3. Bond interest is a deductible expense for the issuing company.
For example, if the company is in the 30 percent tax bracket, in effect the federal government needs to pay 30 percent of the interest charges in debt. So when a company is planning to raise new capital, convertible bonds are more advantageous than preferred stock.
4. They help a corporation in securing equity financing in a delayed manner.
Because it takes time for the bondholders to trade their bonds for stock, this delays the common stock and the earnings per share dilution.
5. Corporations can sell bonds at a lower coupon rate.
Because there is an option to purchase stocks, companies can sell convertible bonds at a lower coupon rate than standard bonds.
List of Disadvantages of Convertible Bonds
1. The company has the right to forcibly convert them.
The issuing company has the right to call for forced conversion usually when the price of the stock is higher than the amount it would be if the bond were redeemed. Another instance is during a bond’s call date. This means there is a cap on the capital appreciation of the bond.
2. They are complex securities.
Most new investors tend to be confused if convertible bonds are stocks or bonds because of their characteristics. You also have to consider certain factors that can affect the price of these bonds. These can include the market for the underlying stock and the climate of the interest rate.
3. They are riskier.
If the issuing company files for bankruptcy, holders of convertible bonds have a lower priority claim on the corporation’s assets. The secured debt holders have to be paid off first.
4. They are traded at a premium to the current trading price.
Investors have to allow the stock to reach the conversion price in order to make the conversion effective.
5. They can be disadvantageous to the issuing company.
These investments can dilute the EPS of the corporation’s common stocks, not to mention the company also risks losing control.
As with any type of investment, you should properly weigh if convertible bonds are the ideal type of security for your investing personality and your financial needs.