Issues With Convertible Bond

 In financial circles, a convertible bond, also called convertible note or convertible bond, is a kind of bond that the holder is able to convert into some specified amount of shares of stock in the issuer or funds of equal worth. Often, it is quite similar to other forms of debt. For example, it has interest payments, maturity dates, credit rating, and payment penalties. It may even have redemption requirements. However, note holders are not entitled to vote in certain instances such as payouts of dividends and other common events of holder voting. There is also a convertibility element attached to it, whereby the price of the stock underlying the bond is the same as the price of the note.

In short, we see two elements for convertible bond financing: debt and equity financing. The first one refers to the borrower converting his debt (the convertible bond) into some form of equity. For this, he must secure a loan (a secured loan) at a higher interest rate than his current debt (his unsecured debt). If he succeeds, then he will have fully converted his debt into equity in the issuer's company.

This means that, in order for an investor to convert his bond into equity in the issuer, there must be a predetermined number of shares for sale. The higher the number, the higher the premium paid by the investor on the equity security. The longer the duration, the lower the premium. The issuer has the right to raise the amount up to a certain limit as stated in the indenture. In order to do so, the investor must provide a new indenture to the company and also continue to hold its existing shares until the maturity date. Otherwise, the company can foreclose on the assets used to finance the convertible bond.

Another method of conversion is through redemption. A convertible bond may have two methods of conversion: direct and indirect. With a direct conversion, the issuer issues new convertible bond and the holder of the bond immediately receives cash payment from the issuer. However, with an indirect conversion, the bonds are converted into shares of the issuer's stock and the holders of the bond receive an additional payment, called the coupon. The coupon is equal to the outstanding principal plus the accumulated discount or difference between the value of the face amount and the strike price.

There are several types of convertible bonds. Some popular ones are U.S. Treasuries, municipal, corporate, agency, foreign currency convertible bonds, credit spread, junk, and pledge sources. In general, the most desirable kinds are those denominated in foreign currency. These foreign currency convertible bonds offer investors the opportunity to obtain returns from their investments at a better rate than in the U.S. dollar. They also allow the issuing company to gain additional market exposure.

Since a convertible bond's maturity dates are not fixed, the rate of return can be variable. This is especially true with longer term instruments. Bond dealers may offer traders a wide range of options when determining the strike price of a convertible bond. Traders can choose to buy at the lows and sell at the high. Alternatively, they may opt for a fixed yield date wherein the premium is set at a certain level and the maturity date is determined by the dealer's discretion.

While some dealers prefer to deal with sales of fixed rate instruments, others prefer convertibles that come with the optional convertibles clauses. These are called mandatory convertibles. Through these types of securities, the dealer can agree to sell a security only upon satisfaction of one or more of the following conditions: the interest rate, the coupon, the amount of debt, and the term or duration. Each of these requirements has a different impact on the return obtained from the sale.

Dealers will often deal with both convertible and fixed income instruments. In the course of their business, they must be aware of all of the applicable federal and state tax laws. There are many strategies that they can use to minimize their tax liability. The use of non-recourse debt in transactions is one such strategy. This option means that if the deal does not materialize, there will be no loss suffered due to tax liability. It is important to keep in mind that if the underlying equity or debt contract is not liquid enough, the bonds could face premature conversion.