There are pros and cons to the use of convertible bonds as a means of financing by corporations. One of several advantages of this method of equity financing is a delayed dilution of common stock and 澳洲幸运5官方开奖结果体彩网:earnings per share (EPS).

Another is that the company can offer the bond at a lower coupon rate—less than it would have to pay on a 澳洲幸运5官方开奖结果体彩网:straight bond. The rule usually is that the more valuable the conversion feature, the lower the yield that must be offered to sell the issue; the conversion feature is a 澳洲幸运5官方开奖结果体彩网:sweetener. Read on to find out how corporations take advantage of convertible bonds and what this means for the investors who buy t꧒hem.

Advantages of ♒Debt Financing in Convertible ❀Bonds

Regardless of how profitable the company is, convertible 澳洲幸运5官方开奖结果体彩网:bondholders receive only a fixed, limited income until conversion. This is an advantage for the company because more of the 澳洲幸运5官方开奖结果体彩网:operating income is available for common stockholders. 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 addition, bond interest is a deductible expense for the issuing company, so for a company in the 30% 澳洲幸运5官方开奖结果体彩网:tax bracket, the federal government, in effect, pays 30% of the interest charges on debt.

In this way, bonds have advantages over common and 澳洲幸运5官方开奖结果体彩网:preferred stock to a corporation planning to raise new capital.

What Investors Should ܫLook for in Co✱nvertible Bonds

Companies with poor credit ratings often issue 澳洲幸运5官方开奖结果体彩网: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 澳洲幸运5官方开奖结果体彩网:bond yield.

There are also corporations with weak 澳洲幸运5官方开奖结果体彩网:credit ratings that also have great potential for growth. Such companies will be able to sell convertible 澳洲幸运5官方开奖结果体彩网:debt issues at a near-normal cost, not because of the quality of the bond but because of the attractiveness of the conversion fea⛎ture ⛄for this "growth" stock.

When money is tight and stock prices are growing, even very credit-worthy companies will issue 澳洲幸运5官方开奖结果体彩网: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 ꦇhigher than the current common ꦕstock price.

By this logic, the convertible bond allows the issuer to sell common stock indirectly at a price higher than the 澳洲幸运5官方开奖结果体彩网:current price. From the buyer's perspective, the convertible bond is attractive becaus🌌e it offers the opportunity to obtain the potentially large return associated with stocks but with the safety of a bond.

Convertible bonds are offered based on them being converted to a set number of shares. However, a company might also issue bonds that are convertible at a specific fixed dollar value. If the share price declines, it can motivate these holders to convert because they will receive more shares for their dollar. The action can further drive share prices down, so this bond is known as 澳洲幸运5官方开奖结果体彩网:death spiral debt.

The Disadvantages of Convertible Bonds

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 澳洲幸运5官方开奖结果体彩网:investment banker or insurance company, a conversion may shift the voting control of the company away from it♏s 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 ha🍬ve just gone public.

Many of the other disadvantages are similar to the disadvantages of using straight debt in general. To the corporation, convertible bonds entail significantly more risk of 澳洲幸运5官方开奖结果体彩网:bank­ruptcy than preferred or common stocks. Furthermore, the shorter the maturity, the greater the risk. Finally, note that the use of 澳洲幸运5官方开奖结果体彩网:fixed-income securities magnifies losses to the common stockholders whenever sales and earnings decline; this is the unfavorable aspect of﷽ financial leverage.

The 澳洲幸运5官方开奖结果体彩网:indenture provisions (restrictive covenants) on a convertible bond are generally much more stringent than they are either in a short-term 澳洲幸运5官方开奖结果体彩网:credit agreement or for common or preferred stock. Hence, the company may be subject to much more disturbing and crip­pling restrictions under a 澳洲幸运5官方开奖结果体彩网:long-term debt arrangement than would be the case if it had borrowed on a sho🐻rt-term basis, or if it had issued 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. Furthermore, in such times, investors are increasingly concerned with the security of their investments, and they may refuse to advance funds to the company except on the basis of well­-secured loans. A company that finances with convertible debt during good times to the point where its debt/assets ratio is at the upper limits for its industry simply may not be able to get financing at all during times of stress. Thus, corporate treasurers like to maintain some "reserve borrowing capacity." This restrains their use of 澳洲幸运5官方开奖结果体彩网:debt financing during normal times.

Why Companies Issue Convertible Debt

The decision to issue new equity, convertible and fixed-income securities to raise capital funds is governed by a number of factors. One is the availability of internally generated funds relative to total financing needs. Such availability, in turn, is a function of a company's profitability and 澳洲幸运5官方开奖结果体彩网:dividend policy.

Another key factor is the current market price of the company's stock, which determines the 澳洲幸运5官方开奖结果体彩网:cost of equity financing. Further, the cost of alternative external sources of funds (i.e., interest rates) is of critical importance. The cost of borrowed funds, relative to 澳洲幸运5官方开奖结果体彩网:equity funds, is significantly lowered by the deductibility 🌱of interest payments (but not of dividends) for federal income tax purposes.

In addition, different investors have different 澳洲幸运5官方开奖结果体彩网:risk-return tradeoff preferences. In order to appeal to the broadest possible market, corporations must offer securities that interest as many different investors as possible. Also, different types of securities are most appropriate at different points in time.

The Bottom Line

Used wisely, a policy of selling differentiated securities (including convertible bonds) to take advantage of market conditions can lower a company's overall 澳洲幸运5官方开奖结果体彩网:cost of capital below what it would be if it issued only one class of debt and common stock. However, there are pros and cons to the use of convertible bonds for financing; investors s🧜hould consider what the issue means from a corporate standpoint before buying in.