Tony taught Business and Aeronautics courses for eight years; he holds a Master's degree in Management and is completing a PhD in Organizational Psychology
What are Bonds?
Bonds are one type of negotiable instrument that can be issued, when a company wants to borrow money. The term negotiable instrument applies to many types of agreements that guarantee payment of money at some time in the future. Bonds issued by companies are called corporate bonds, and they are sold to investors. This way, organizations can raise money without borrowing it from a bank.
Investors will purchase bonds from a company for the par (base) value, usually for $1,000 each. In return, the company will pay back that amount with interest as they make profits in the future. The reputation of the company, and expectation of future earnings are the main concerns for investors. Occasionally, there are special types of bonds that have collateral in case the company does not earn profits from the money that was borrowed.
Convertible Bonds Defined
Convertible bonds give the investor the option of exchanging the bond for a certain amount of common stock (ownership) in the company, or the amount of money that is equal to the stock's value. If the company does well in the future, the value of the bond increases as the value of the amount of stock it can be traded for, goes up. The fact that there is an opportunity to trade the bonds for shares of stock means that companies that would be at a higher risk (due to bad credit history), would be able to issue convertible bonds at a much lower interest rate, than they would if they sold a regular bond. If the company does not do well financially, and the stock value is less than the bond value, then the investor can just receive the interest and bond amount (par value) back at the end of the period.
The number of shares of stock that are given for each convertible bond is called the conversion ratio. The conversion ratio would be stated in the beginning with a list of other conditions provided at the time of the bond's sale. For example, a $1,000 bond may be converted for 20 shares of stock if the company's stock is valued at around $50 per share. If the value of each share goes up, then the benefit of the conversion increases also.
Examples of Convertible Bonds
In 2010, Profits, Inc. sells you one of their convertible bonds for a $1,000 investment, and will pay you 5% interest per year, also called the coupon rate. The bond's provisions also state that the bond can be converted at a ratio of 50:1 (fifty shares of stock for one bond). The current stock price is $25 per share. After a period of high profits and good publicity, the stock's price is now at $40 per share. The investor can take the bond and convert it into fifty shares of stock for a value of $2,000 ($40 per share times 50 shares). The investor would have earned whatever interest was provided during that time, as well as a $1,000 profit from the conversion.
In 2014, Profits, Ins. sells you a new convertible bond for a $1,000 investment and will pay a 6% coupon rate. The bond's provisions state that there is a conversion ratio of 20:1 and the current stock price is $45 per share. Unfortunately, Profits, Inc. made some bad investments and their stock price falls back down to $25 per share, and stays there until the bond's maturity date. Even though it is not worth it to convert the bond, the investor will still earn the 6% interest per year, and be able to get the initial investment of $1,000 back upon maturity.
Negotiable instruments are used by companies to raise funds for future growth. One type of negotiable instrument is a convertible bond. Convertible bonds can be exchanged for shares of stock if a company does well financially, and their stock price increases before the bond's maturity date. The number of shares of stock that can be exchanged for the bond is called the conversion ratio.
When organizations perform well, the value of the bond goes up as its conversion value increases. On the other hand, if the company does not do so well, then the investor will still be able to earn the coupon rate, and get their initial investment back at the end of the bond's maturity.
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