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Convertible bonds

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Convertible bonds are corporate bonds that give the investor the right to convert the bonds into shares of the issuer under predetermined terms. Thus, convertible bonds are hybrid securities, which, being a debt instrument, provide an opportunity to become a shareholder of the company.

The terms of the conversion should include such parameters as the conversion rate and the conversion price. The conversion ratio shows how many shares can be received in exchange for one convertible bond. The conversion price is the price at which the investor will receive the shares at the time of the conversion.

Other parameters of a convertible bond include conversion value and conversion premium. The conversion value reflects the amount of money that the investor will receive during the conversion at the current moment. The conversion premium is the difference between the conversion value and the current value of a bond.

When choosing securities, it is also worth looking at the conversion period; for some bonds, it may be limited by the issuer. Sometimes convertible bonds have an embedded call option, which gives the issuer the right to redeem them early and limit the investor’s return.

Benefit for the issuer

• The coupon rate on convertible bonds is lower than on ordinary bonds.
• Compared to issuing shares, issuing convertible bonds allows the dilution of shareholders’ shares to be postponed until a later period.

The price of a convertible bond is affected by three main components: the interest rate, the price of the associated share, and the credit quality of the issuer. The value of a convertible bond is calculated by adding the value of the bond and the value of the conversion option. The value of the bond is calculated by classical cash flow discounting, as if the bond were not convertible.
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