HIGH Grade Convertible Bonds. By T.J. Kaleikini. What is a Bond?.
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a certificate of debt (usually interest-bearing or discounted) that is issued by a government or corporation in order to raise money; the issuer is required to pay a fixed sum annually until maturity and then a fixed sum to repay the principal
The exchange feature of a convertible bond gives the right for the holder to convert the par amount of the bond for common shares a specified price or "conversion ratio". For example, a conversion ratio might give the holder the right to convert $100 par amount of the convertible bonds of Ensolvint Corporation into its common shares at $25 per share. This conversion ratio would be said to be " 4:1" or "four to one".
Example Let’s say that TSJ Sports issues $10 million in three-year convertible bonds with a 5% yield and a 25% premium. This means that TSJ will have to pay $500,000 in interest annually, or a total $1.5 million over the life of the converts. If TSJ’s stock was trading at $40 at the time of the convertible bonds issue, investors would have the option of converting those bonds for shares at a price of $50 ($40 x 1.25 = $50). Therefore if the stock was trading at say $55 by the bond's expiration date, that $5 difference per share is profit for the investor. However there is usually a cap on the amount the stock can appreciate through the issuer’s callable provision. For instance, TSJ executives won’t allow the share price to surge to $100 without calling the converts (recall the paragraph on forced conversion). Alternatively, if the stock price tanks to $25 the convert holders would still be paid the face value of the $1,000 bond at maturity. This means that convertible bonds limit risk should the stock price plummet, while limiting exposure to upside price movements of the underlying common stock.
Probably the most frustrating aspect of a convertible is its call feature - often overlooked in its evaluation. If interest rates should decline significantly after the convertible bond is issued, most companies can and will call their bonds, in which case one loses the source of what had been a relatively attractive income, and must then reinvest the proceeds in another vehicle at the then lower rates of interest. On the other hand, if interest rates go up, there is no chance that the bond will be called, and so the investor is stuck with a lower-than-market rate of interest on the bonds. This is an example of a "heads, you lose; tails, you don't win" type of investment