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Convertible bonds hold more credit DNA than equity. As such, a careful credit analysis process needs to be set up in order to assess both the quality of the convertible bonds and the strength of the bond floor in particular, which is closely linked to the credit spread of the company. At best, the investor will be able to convert the bond into equity and will become a shareholder. At worst, the company will redeem the bond in cash, making the convertible bond one of the best non-conventional tools to safeguard initial invested capital.
Convertible bonds are fixed-coupon instruments with an embedded conversion option into common shares. Put most simply, convertible bonds combine a straight bond and an equity call option.
The rationale for issuers is to decrease the financing cost with a lower coupon than for an equivalent straight bond. The fixed income component is called the bond floor (the present value of the coupons and the final maturity amount) that will be returned to investors if the bond is not converted. The difference between the market price and the bond floor equals the value of the equity call option. The bondholder can convert at any time during the life of the bond provided the value of the bond is higher than the bond floor.
The most common convertible bond structures could be summarised as follows:
As convertible bonds are primarily debt instruments, convertible bondholders have greater seniority than equity shareholders. Bonds are typically safer investments than equity because bondholders usually have a first claim on the company’s assets in case of bankruptcy.
1 Under IFRS and IAS32, the equity option and the debt component of convertible bonds is accounted for separately in the balance sheet of the issuer. On issue, approximately 85-90% will be recorded as debt and the remainder in equity. For Net Shares Settlement-like issues, the options will be marked-to-market in the profit and loss account, but the issuer may limit the dilution effect.