Convertible bonds are nowadays being used by companies to finance. There are plus sides as well as negative aspects to the introduction of convertible. Here they are:
Advantages of Debt Financing in Convertible Bonds
Any convertible bondholder will receive limited income till conversion happens and the common stockholders easily get more income they can operate. Even the voting controls aren’t in the hands of the bondholders but only the common stockholders. If during any time, the company has an idea to finance in a different way, they can sell the convertible bonds. As the interest on bonds is deductible, a company in 30% tax classification has 30% of the debt interest paid by the federal government.
Disadvantages of convertible bonds
With every good quality comes a disadvantage which needs to be worked out and convertible bonds are no different. The EPS of the company stock may get diluted and the same fate can be suffered by the control of the company. The other drawbacks are very much similar to having straight debt. Convertible bonds bring with them a higher risk of bankruptcy compared to common stocks for any given company. And this increases if the maturity is short. Comparing a short-term credit agreement to convertible bonds, it is found that convertibles are not as flexible. Obviously, such heavy use of debt will affect financing abilities of a company when there is economic stress.
Why do companies issue convertible debt?
To raise capital funds, convertibles are offered and depend on some factors. The first of those would be if internally generated funds relative to total financing needs are available or not. This is completely relying on the profit a company makes and its dividend policy. The market price that the company’s stock currently holds is the factor which determines the cost of their equity financing. This happens to be the second most important reason. Not just these two, but it must be understood that all investors have varying risk-return tradeoff preferences. Their intent is obviously to work out a way in which they can appeal to a really brad market.
What should investors look for in convertible bonds?
Companies which have poor credit ratings are the ones who mostly offer convertible bonds. They do so in order to reduce the necessary yield so they are able to sell their securities. Any investor must be aware that financially weak companies do so without intending to convert the issue. That being said, investors must be aware that there are times when money is tight and the stock prices are on the rise. These are the times when companies who are doing good also issue convertibles so that they can reduce their cost of obtaining scarce capital.