January 26, 2022

Accounting + Finance Blog

Convertible Bond Meaning and Key Explanations

A convertible bond is corporate debt and is available for conversion to equIty capital as per the agreement in the bond’s certificate. They may be preferable if the bondholders want to be a part-owner of the company in the future.

Definition of Convertible Bond

A convertible bond means a bond whose holder has the option of converting their portion of bonds into ordinary shares on or before maturity.

Key Explanations Convertible Bond

Convertible bonds are usually long-term debts with maturity dates ranging from five to ten years. During these years the bondholders may exercise their option to convert them to shares if the conversion value is lower than the shares price. Investors should invest in this bond if there’s potential for growth in the value of the shares of the issuing company.

They are converted using a conversion ratio. For example, if the conversion ratio is 20 for a bond of 1000 Naira each. Then, the conversion value is 50 Naira (1000 divided by 20). If the share price at the date of conversion is higher than 50 Naira (that is, the conversion price). Then the bondholders can push for conversion to equity capital. However, if the opposite occurs, the investors will wait till maturity. Therefore, the convertible bondholders win on all sides.

Just like every other type of bond, they received fixed income every quarter. A coupon rate is normally attached to this debt capital. In the above example, a 5 percent fixed interest rate may apply. If that is the case, the bondholder will earn a fixed income of 50 Naira at every 1000 Naira bond held.

One interesting aspect of this debt financing is that the holder will be repaid their principal amount if the company liquidates before the conversion date. Or before the maturity date, as the case may be. They will be paid along with other bondholders equally before equity shareholders receive any money. However, the fixed interest rate for convertible bonds is usually lower than other types of bonds.

How to Convert Convertible Bonds to Shares Capital

Normally, the ratio of conversion is stated in the certificate. For example, a convertible bond of 1000 Naira at a 2% coupon rate. This may have a conversion ratio of 10 shares to every bond held (which is 10:1). This means that every holder will get 10 shares for every one bond held. So, if a bondholder has 500 bonds at 1000 Naira. Then, he will receive 5000 ordinary shares (500 × 10 shares).

Conclusion

A convertible bond gives the holder the option to convert into equity shares of the issuing company. The investors may exercise their option if the converting value is lower than the share value at the date of conversion. More so, just like every other bond, holders received fixed interest rates as income.