Convertible Debt

Convertible debt, also known as convertible bond, is a debt instrument that can convert into equity shares later. It is hybrid security as it contains both debt and equity features and offers added advantages to the holder.

To make a profit on conversion, the market price of the equity shares should be greater than or equal to the conversion price. In such a scenario, the bondholder would be more likely to exercise the option of conversion. Whereas, if the equity shares are trading at a value lesser than the conversion price, the bondholder stands to make a loss and would be more likely to retain the debt interest.

• Convertible debt refers to a type of debt instrument, usually in the form of bonds or debentures, that can be converted into a predetermined number of the issuer's equity shares at the option of the bondholder.
• The critical feature of convertible debt is the conversion option it provides to bondholders. This option allows bondholders to convert their debt holdings into equity shares of the issuing company at a specified conversion price and within a predetermined conversion period.
• Convertible debt offers bondholders the potential to benefit from future increases in the value of the issuing company's equity. If the stock price rises above the conversion price, bondholders can convert their debt into equity, resulting in capital gains and participation in the company's growth.

Convertible debt is an easier way of raising funds for a company that benefits investors’ debt and equity features. In addition, this type of debt offers more advantages than a traditional debt instrument when invested correctly.

Like a common bond, the company issues convertible debt instrument with a coupon rate (interest rate) and a maturity date and can be converted into equity shares upon meeting certain conditions or after a certain period, based on the type of convertible debt issued.

Suppose the value of equity shares of the company remains low or does not offer significant growth. In that case, the bondholder may choose to retain their instrument in the form of debt and redeem it upon maturity.

Alternatively, if the value of equity goes up significantly, the bondholder may choose to convert his debt into convertible debt offering.

With the following formula, the relationship between the conversion ratio and the price will be understood –

Conversion Price = Value of Convertible Debt/Conversion Ratio.

1. Coupon Rate – Like a traditional debt instrument, a convertible debt also requires the issuer to pay interest to the holder periodically. The interest rate may be fixed or floating, depending on the terms of the instrument.
2. Maturity Date – Debts are issued for a particular period. The maturity date is when all the dues payable are paid in full to the holder. In some instruments, the maturity date is when the debts are converted into equity shares. However, in other cases, the holder may choose not to exercise his right of conversion, and the debt instrument would be repaid in full at the maturity date.
3. Conversion Ratio – A conversion ratio specifies the number of equity shares the bondholder receives upon conversion. Simply put, it is the number of equity shares offered by the company per unit of debt. The conversion ratio is pre-determined at the issuance of the convertible debt. For example, a convertible ratio of 10 means that will receive 10 equity shares upon conversion for every unit of debt.
4. Conversion Price – Similar to the conversion ratio, the conversion price is pre-determined when issuance. It is the price per unit of equity stock at the conversion time.

Let us take some examples to understand convertible debt instrument.

Example #1

Mr. X holds convertible bonds to the value of $1,000 (10 bonds of $100 each). The conversion price is $50. The conversion ratio = 20 (1000/50). That means 20 equity shares are offered for each bond held for conversion. The total number of shares Mr. X shall be eligible to upon conversion = 10*20 = 20 shares of $50 each.

In the same scenario, where only the conversion ratio is given, may calculate the conversion price as – 1000/20 = $50.

Example#2

Let us understand this concept by taking Mr. X’s example. The total debt value is $1,000, and the conversion price is $50. When the market price per equity share is $55, the profit that Mr. X stands to make is $5*20 = $100 ($5 per share).

Alternatively, when the market price of the share is $40, then Mr. X stands to make a total loss of $10*20= $200 on the investment ($10 loss per share).

Below are the types of convertible debt financing.

#1 - Vanilla Convertible Bonds

It is the most common form of convertible debt wherein, at the time of maturity, the bondholder can convert the bond into equity based on the conversion price, ratio, and market price or may choose to redeem the value of the convertible debt offering.

#2 - Mandatory Convertible Bonds

As the name suggests, the bonds are mandatorily converted into equity shares upon a specified conversion date and rate. This type of debt does not offer any choice to the holder in terms of the conversion of the debt. Repayment towards a debt instrument is two-fold – repayment of interest and repayment of principal. In the case of mandatorily convertible debentures, the repayment of the principal takes the form of equity shares rather than cash.

It is a cash saving mechanism employed by the company wherein the available cash is utilized for developmental and expansion purposes instead of debt repayment. The conversion ratio and price are pre-determined at the time of issuance of convertible debt financing and are priced in such a manner that the holder gets the par value of the stock – no premium, no discount.

#3 - Reversible Convertible Bonds

In the case of reversible convertible bonds, the company has the option to convert the bonds into equity shares or retain them in the form of debt, unlike the vanilla convertible bonds wherein the bondholder has the option to convert.

• From the investor’s perspective, convertible debt benefits both debt and equity. The bondholder receives periodic interest payments on the debt and may also enjoy the benefit of capital appreciation if the company performs well.
• From the company’s perspective, convertible securities easier to raise funds without diluting the capital structure in the short term.
• This type of financing would be most suitable for small-scale companies and startups to raise funds easily without any dependence on past performance.

• Considering that there is an option to convert the convertible debt agreement into equity and gain capital appreciation, companies are more likely to offer a lower interest rate (coupon rate) on this type of debt.
• As this type of debt is more complicated in which many variables need to be considered. The average individual investor would be more likely to opt for traditional debt instruments.

• It is easy and less time consuming to issue convertible debt agreement than equity.
• Issuing the debt does not give the investors any right in the company operations, unlike equity. Thus the power remain with the management if the company issues debt instead of equity.
• Since the debt is convertible into equity in the future, it is difficult to account for the actual debt portion in the business.
• If the company is not able to earn enough revenue or if the debt has no automatic conversion policy, the investors may not get their fund back. This risk is not there in case of equity.  

This article has been a guide to what is Convertible Debt. We explain the accounting method along with examples, differences with equity, types & advantages. You can learn more about accounting from the following articles –

• Convertible Securities | Types
• Dilutive Securities
• How does a Callable Preferred Stock Work?
• Stock Warrant