Convertible securities come in many forms—convertible notes, convertible bonds, and convertible preferred shares, to name a few. Generally, they are interest-bearing, fixed-income debt securities that may also be converted into a predetermined number of common stock or equity shares, meaning they combine features of debt and equity. When a company is looking for alternative means of financing, convertible securities hold numerous advantages over common and preferred stock. Convertible securities can also be a compelling option for investors, but both parties should ensure that they are well-informed of the risks.
Companies offer convertible bonds at lower coupon rates, and because corporations only need to share operating income with the newly converted shareholders when performance is good, they benefit by holding onto more of their cash. In addition, bond interest is a deductible expense for the issuing company, meaning that the federal government will pay for a percentage of the interest charges on the debt.
Selling convertible bonds is also an advantage for organizations that do not want to lose voting control of the business. However, since bonds do convert to stocks eventually and stockholders are entitled to vote for directors, the benefit is usually temporary. Companies with weak credit ratings may also sell convertible securities to lower the yield necessary to sell their debt securities.
Companies should also be aware of the risks. Financing with convertible securities may dilute the earnings per share (EPS) of the issuer’s common stock. And, while convertible securities stave off yielding control of the company to others for a time, if a large part of the issue is purchased by an investment banker or insurance company, a conversion could shift voting control away from owners. Other disadvantages mirror those of utilizing straight debt, although convertible bonds do entail a greater risk of bankruptcy than preferred or common stocks, and the shorter the maturity, the greater the risk. If it does not convert, for example, the company may be forced to repay the money within a very tight timeframe.
Investors are drawn to convertible securities because they could yield the high returns associated with stocks, combined with the lower risk of bonds. By investing in debt, and essentially lending money to a company, investors are given more protections since they are technically considered creditors rather than owners and, if the company goes out of business, creditors are always paid before shareholders. These transactions also cost less than stock sales, making them a relatively safe and cost-effective way to invest.
Yet, investors are typically providing funds to unproven companies whose values are not yet known. Credit-worthy companies often issue convertibles to reduce the cost of obtaining capital. Sometimes, however, companies with poor credit ratings will issue them without the intention of ever converting the issues. Some corporations with weak credit ratings still have a high potential for growth, but investors must study the company’s performance and industry standing to make an informed decision about its likelihood for future success. The rate of return must be high enough to reward the risk.
Convertible debt has become a common financing tool, especially for entrepreneurs trying to fund start-ups, and it is a great way for investors to engage with this landscape with some built-in safety features. These transactions are quick, relatively easy, and beneficial for all involved, as long as everyone has done their homework.