What Are the Circumstances of Convertible Debt?
- Some bonds can be converted into shares of stock.savings bonds image by Stephen VanHorn from Fotolia.com
Convertible debt usually refers to bonds. When a bond is convertible, the owner can trade it for equity in the company, receiving shares of stock. The company no longer has to pay the interest and the principle on the debt, but it does have to provide stock to the new stockholder, which dilutes the stock holdings of existing investors. In some circumstances, convertible debt is a good option for a company to offer investors. - A company can offer convertible debt when it already has a high debt burden. The terms of a loan may punish a company, which has excessive debt, forcing it to pay a higher interest rate when borrowing additional funds or even preventing it from borrowing additional funds. When the company offers convertible debt, it is providing an incentive to convert debt instruments into equity instruments, reducing its overall debt.
- A bank may offer mandatory convertible debt to investors. Mandatory convertible debt must be converted to shares of stock before the convertible bond matures. According to the Treasury, when a bank sells mandatory convertible debt, this debt must convert to stock within a period of 12 years. Banks sell mandatory convertible debt so that they can meet federal capital reserve requirements.
- Bondholders prefer convertible debt when they cannot easily determine the risk of investing in a company. If investors know all of the facts about a company's future projects, they can easily decide whether purchasing stock in the firm or purchasing the firm's bonds will provide greater returns in the future. When the bondholder has questions about the firm, such as whether its business model will remain profitable, convertible debt allows the investor to decide which type of investment to select in the future after observing the results of a company's business decisions.
- Convertible debt protects bond owners who believe that the company will issue more debt in the future. If the company goes bankrupt, other bond owners will be able to fight the current bond owners for the company's assets during liquidation. If the company is profitable after borrowing additional money, the current bond owners will not receive any further benefits, and future bond buyers may even earn higher interest rates from the company's bonds if the company issues additional bonds while it has a high debt load.
- A company can sell convertible debt, which pays a lower interest rate than other types of debt. Other debt buyers cannot convert their debt into stocks, so they will demand a higher interest rate from the company before purchasing its bonds. This reduces the company's immediate expenses, although the stock conversion and subsequent stock dilution can cost stockholders more money than the interest the company must pay on nonconvertible bonds if the company is highly profitable.
