Why issue convertible stock

I Accept Show Purposes. Your Money. Personal Finance. Your Practice. Popular Courses. Bonds Fixed Income Essentials. Key Takeaways A convertible bond is a hybrid security that offers investors the option to cash it in at the end of its term or convert it to shares in the company. Convertible bonds offer lower interest rates than comparable conventional bonds, so they're a cost-effective way for the company to raise money.

Their conversion to shares also saves the company cash, although it risks diluting the share price. Tesla's Gigafactory was built with money raised in a convertible bond issue. Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace.

Related Articles. Convertible Notes How is convertible bond valuation different than traditional bond valuation? Dividend Stocks Understanding Preferred Stocks. Partner Links. A "convertible security" is a security—usually a bond or a preferred stock—that can be converted into a different security—typically shares of the company's common stock.

In most cases, the holder of the convertible determines whether and when to convert. In other cases, the company has the right to determine when the conversion occurs. Companies generally issue convertible securities to raise money. Companies that have access to conventional means of raising capital such as public offerings and bank financings might offer convertible securities for particular business reasons.

Companies that may be unable to tap conventional sources of funding sometimes offer convertible securities as a way to raise money more quickly. In a conventional convertible security financing, the conversion formula is generally fixed - meaning that the convertible security converts into common stock based on a fixed price. The convertible security financing arrangements might also include caps or other provisions to limit dilution the reduction in earnings per share and proportional ownership that occurs when, for example, holders of convertible securities convert those securities into common stock.

By contrast, in less conventional convertible security financings, the conversion ratio may be based on fluctuating market prices to determine the number of shares of common stock to be issued on conversion.

A market price based conversion formula protects the holders of the convertibles against price declines, while subjecting both the company and the holders of its common stock to certain risks. Convertible bonds can add value within a diversified portfolio by reducing risk while maintaining expected return. Convertibles offer greater potential for appreciation than ordinary corporate bonds and the investor can convert to benefit from stock price gains.

In a fixed income portfolio, convertibles can enhance returns through exposure to equity-driven price increases and reduce impact of rising interest rates. In an equity portfolio, convertible bonds can help reduce downside risk without foregoing all upside potential. Pre-conversion, investors have some protection against default since bondholders are paid before stockholders. Disadvantages of Convertible Bonds Convertible bonds are callable, meaning that the issuer can force investors to convert.

A bond may be issued with a specified call date or the company may call the bond and force conversion if the stock price rises beyond a particular point.

Therefore, the upside potential of the investment may be limited. Convertible bonds are highly correlated to equity markets, meaning their values may be more associated with movements in the stock market than other types of bonds.

Convertibles are sensitive to rising interest rates, although to a lesser degree than plain old corporate bonds. Convertible bondholders are paid a lower coupon rate than corporate bondholders. If many convertible bondholders exercise the conversion option, dilution may occur with attendant negative effects on stock price. Companies that issue convertibles may have weaker credit ratings Convertible bonds are of lower priority than straight bonds in the event of default and are unsecured, meaning if a company goes bankrupt, you may not be repaid the amount you lent them.

How to Buy Convertible Bonds There are several ways to invest in convertible bonds. Should You Buy Convertible Bonds? Was this article helpful? Share your feedback. Send feedback to the editorial team. Rate this Article. Thank You for your feedback! Something went wrong. Please try again later. Best Ofs. More from. The company only has to share operating income with the newly converted shareholders if it does well.

Typically, bondholders are not entitled to vote for directors; voting control is in the hands of the common stockholders. Thus, when a company is considering alternative means of financing, if the existing management group is concerned about losing voting control of the business, then selling convertible bonds will provide an advantage, although perhaps only temporarily, over financing with common stock. In this way, bonds have advantages over common and preferred stock to a corporation planning to raise new capital.

Companies with poor credit ratings often issue convertibles in order to lower the yield necessary to sell their debt securities. The investor should be aware that some financially weak companies will issue convertibles just to reduce their costs of financing, with no intention of the issue ever being converted. As a general rule, the stronger the company, the lower the preferred yield relative to its bond yield. There are also corporations with weak credit ratings that also have great potential for growth.

Such companies will be able to sell convertible debt issues at a near-normal cost, not because of the quality of the bond but because of the attractiveness of the conversion feature for this "growth" stock. When money is tight, and stock prices are growing, even very credit-worthy companies will issue convertible securities in an effort to reduce their cost of obtaining scarce capital. Most issuers hope that if the price of their stocks rises, the bonds will be converted to common stock at a price that is higher than the current common stock price.

By this logic, the convertible bond allows the issuer to sell common stock indirectly at a price higher than the current price. From the buyer's perspective, the convertible bond is attractive because it offers the opportunity to obtain the potentially large return associated with stocks, but with the safety of a bond. There are some disadvantages to convertible bond issuers, too. One is that financing with convertible securities runs the risk of diluting not only the EPS of the company's common stock but also the control of the company.

If a large part of the issue is purchased by one buyer, typically an investment banker or insurance company, a conversion may shift the voting control of the company away from its original owners and toward the converters. This potential is not a significant problem for large companies with millions of stockholders, but it is a very real consideration for smaller companies or those that have just gone public.

Many of the other disadvantages are similar to the disadvantages of using straight debt in general. Furthermore, the shorter the maturity, the greater the risk. Finally, note that the use of fixed-income securities magnifies losses to the common stockholders whenever sales and earnings decline; this is the unfavorable aspect of financial leverage. The indenture provisions restrictive covenants on a convertible bond are generally much more stringent than they are either in a short-term credit agreement or for common or preferred stock.

Finally, heavy use of debt will adversely affect a company's ability to finance operations in times of economic stress. As a company's fortunes deteriorate, it will experience great difficulties in raising capital.