What are Convertible Bonds & how do they work?

In investments, finding a balance between risk and reward is key. Convertible Bonds offer a unique blend of features, combining the stability of bonds with the growth potential of equities. Whether you're an experienced investor or just starting, understanding Convertible Bonds can open up new avenues for portfolio diversification and potential gains.

What is a Convertible Bond?

A Convertible Bond is a type of debt security that can be converted into a predetermined number of the issuing company's equity shares. It essentially starts as a bond, providing fixed interest payments, but includes an option to convert into equity, allowing participation in the company's growth.

Features of Convertible Bonds

• Conversion option: Convertible Bonds enable you to exchange your bonds for a specified number of shares of the issuing company. This conversion can be exercised at predetermined times, depending on the conversion ratio and conversion price.
• Interest payments: These bonds provide periodic interest payments, also known as coupon payments, offering a consistent income stream.
• Maturity date: Convertible Bonds have a set maturity date, at which the principal amount is returned to you. This term usually spans from 5 to 10 years.
• Conversion ratio: This ratio indicates the number of shares you can receive upon conversion. For instance, a conversion ratio of 20 allows each bond to be converted into 20 shares.
• Conversion price: The conversion price is the amount needed to convert the bond into shares, determined by dividing the bond's par value by the conversion ratio. For example, a ₹1,000 bond with a conversion ratio of 20 would have a conversion price of ₹50.
• Call and Put Options: They offer flexibility, with Call Options allowing the issuer to buy back the bonds before maturity at a premium and Put Options allowing you to sell the bond back to the issuer at a predetermined price.

Advantages of Convertible Bonds

• Potential for capital appreciation: If the company's stock performs well, the Convertible Bond's value can see substantial growth.
• Steady income: These bonds provide regular interest payments, ensuring a consistent income stream for investors.
• Downside protection: In case the company's stock does not perform well, you still benefit from interest payments and receive the principal amount at maturity.
• Flexible conversion: You have the advantage of timing the conversion of your bonds into shares to maximise potential gains.

Disadvantages of Convertible Bonds

• Lower interest rates: Due to the added benefit of potential conversion, Convertible Bonds often have lower interest rates compared to standard bonds.
• Market risk: The value of Convertible Bonds is tied to the performance of the underlying stock, which introduces an element of equity market risk.

How does a Convertible Bond work?

Consider buying a ₹10,000 Convertible Bond with a 5% annual interest rate, 10-year maturity, conversion ratio of 50 and conversion price of ₹200.

• Interest payments: You earn ₹500 annually (5% of ₹10,000).
• Conversion option: If the stock price rises to ₹250, you can convert the bond into 50 shares, now worth ₹12,500 (50 x ₹250).
• Decision point: You can either convert to shares for potential gains or hold the bond to maturity for interest and principal repayment.

Also Read: A complete guide on equity investment

Wrapping up

Convertible Bonds offer a versatile investment option, blending the stability of bonds with the growth potential of stocks. They provide regular interest payments and the option to convert to equity, making them a valuable addition to any diversified portfolio.

Disclaimer: This article is for information purpose only. The views expressed in this article are personal and do not necessarily constitute the views of Axis Bank Ltd. and its employees. Axis Bank Ltd. and/or the author shall not be responsible for any direct / indirect loss or liability incurred by the reader for taking any financial decisions based on the contents and information. Please consult your financial advisor before making any financial decision.