Introduction -
Convertible bonds are, customarily, fixed rate debt instruments issued by a company (the “issuer”), the terms of which allow the holders of the bonds to convert them into ordinary shares (common stock) of the company at a prescribed conversion price and during a prescribed conversion period.
Convertible bonds may be seen as a combination of two separate financial instruments – namely:
- a fixed rate bond, and
- an embedded equity call option.
This combination of features provides investors in convertible bonds with certain distinct advantages over a similar investment in plain vanilla bonds or the ordinary shares of the company. In very general terms, convertible bonds are capable of offering investors equity upside potential in the ordinary shares of the relevant company as a result of the equity call option and, at the same time, capped downside risk as a result of the fixed rate bond’s periodic coupon payments and the ultimate return of principal on the final maturity date. This equity upside potential and capped downside risk is often termed “Optionality” by convertible bond practitioners.
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