Convertible bonds are used by corporations as a way to finance the companies. There are very good advantages to using these assets, but there are also very real risks that you have to bear in mind.

Advantages of Convertible Bonds

No matter how profitable the company is, those who hold convertible bonds receive fixed, limited income until the bond is finally converted. This can be beneficial for the company since more of the operating income is available for common stockholders.

The company only needs to share operating income with the newly converted shareholders if it performs well enough. Usually, bondholders are not entitled to vote for directors and the voting power is in the hands of the common stockholders.

Therefore, if a company is looking for alternative methods of financing and if the existing management team is worried about losing the voting control of the business, then selling convertible bonds will help provide an advantage over financing with common stocks, albeit only temporarily.

Additionally, bond interest is a deductible expense for the issuing company. For instance, for a company in the 30 percent tax bracket, the federal government pays 30 percent of the interest charges on debt.

For Investors

Companies that have poor credit ratings usually issue convertibles in order to lower the yield necessary to sell their debt securities. The investor should bear in mind that some financially weak companies will issue convertibles just to reduce their costs of financing and have no plan to ever convert the issue. In general, stronger companies have lower preferred yield relative to its bond yield.

Meanwhile, there are corporations that have weak credit ratings that also have great potential for growth. These companies will be able to sell convertible debt issues at a near-normal expense, not because of the quality of the bond but because of the attractiveness of the conversion feature for this “growth” stock.

When funding is tight and the stock prices are increasing, even the most credit-worthy companies will issue convertible securities in an attempt to decrease their cost of obtaining scarce capital. Most of the issuers hope that if the price of their stocks rise, the bonds will be converted to common stock at a price that is higher than the current common stock price.

Convertible Bonds’ Disadvantages

In spite of the perceived benefits of convertible bonds for investors and companies, there are also existing risks. For one, financing with convertible securities runs the risk of diluting the EPS of the company’s stock as well as the control of the company.

If the bigger part of the issue is purchased by only one buyer, usually an investment banker or insurance company, conversion may switch the voting control of the company away from its original owners and toward the converters.

This doesn’t pose a significant danger for companies with millions of stockholders, but it is a very real for smaller companies and those that have only gone public.

Meanwhile, the other risks are very much similar to those found in straight debt. For the corporation, convertible bonds mean substantially higher risk of bankruptcy than preferred or common stocks. Further, shorter maturity means greater risk.