What is Convertible Debt?
April 8, 2022
What is Convertible Debt?
Convertible debt is a type of fixed income instrument that may be converted into a predetermined number of shares of common stock, typically at the discretion of the bondholder. Convertible debt is also known as convertible notes or convertible bonds. Issuing convertible debt is an alternative to issuing stock to raise capital. The benefit of convertible debt to an investor, compared to an ordinary bond, is the option to convert the bond into common stock. If the market price is higher than the conversion price at the time of conversion, the investor will profit. The issuer benefits from lower borrowing costs since investors are compensated by the upside potential of the stock in addition to the interest paid.
Key terms used in convertible debt:
Interest Rate –The issuer of convertible debt pays interest to the holder periodically. The interest rate may be fixed or floating, depending on the terms agreed.
Maturity Date –The maturity date is the date upon which the principal is to be repaid to the bondholder if they have not exercised the conversion option.
Conversion Rate – The conversion rate is the quantity of shares the bondholder receives upon conversion. The conversion rate is pre-determined at the issuance of the convertible debt. Sometimes it is also referred to as the conversion ratio.
Conversion Price – The conversion price is the price to be paid per share of stock at conversion.
Key Learning Points
- Convertible debt is a hybrid security that contains both debt and equity features and offers additional advantages to the bondholder.
- Convertible debt is like an ordinary bond, in that it bears a coupon rate with the principal to be repaid on the maturity date. The difference is convertible debt can be converted into equity shares upon certain conditions are met.
- Conversion typically takes place at the investor’s discretion. The investor will choose to convert if the stock’s market price exceeds the conversion price, profiting by the amount of the difference. If the option to convert is not exercised, the bondholder still receives interest income and the principal at maturity.
- Convertible debt is often used in early-stage fundraising, as a convertible issue does not compel the issuer and investors to agree on a valuation. The valuation is typically conducted during the next round of financing when more information about the company’s operations is available.
Convertible Debt Example
Bens Creek Group plc, announced on 17 February 2022 that they would issue a convertible loan note (CLN) to raise US$6.0 million. The CLN is being issued to ACAM LP (ACAM or the Lender). The net proceeds will be used to finance future acquisition opportunities, which are likely to enhance the Company’s existing metallurgical coal reserves and upgrade its infrastructure.
The terms of the CLN are summarized as below:
Maturity Date: 2 years from 28 February 2022, which is 28 February 2024
Interest Rate: 12% per annum, payable monthly in arrears, starting from 31 March 2022
Security Coverage: Unsecured
Convertible note unit: multiples of US$ 500,000
Conversion Price: 40 cents per share
Conversion Date: 5 business days prior to 28 February 2024
In this example, if an investor subscribed to 2 units of the CLN, they would hold US$1m in convertible debt.
If the investor chose to hold the instrument until 28 Feb 2024, they would receive US$1.24m, the principal of US$1m plus the total interest of US$240,000. They would gain US$240,000 from the investment.
If the investor opted to convert on 28 February 2023, they would receive a US$120,000 interest payment and 2,500,000 shares of stock. If the Company’s share price rose to 50 cents, the investor could sell the stock for US$1.25m and gain US$370,000 (US$120,000+US$1.25m-US$1m) in profit. If the share price had fallen to 30 cents at the time of conversion, the investor would receive USD$870,000 (US$120,000 interest + US$750,000 from selling 2.5m shares), for a loss of US$130,000. However, if the market price fell below the conversion price, the investor would not opt to convert, thus locking in a loss.
Download the convertible debt workout to practice calculating convertible debt, access the full file to check your workings are correct.
Conclusion
Convertible bonds give the holder the option to convert the instrument to common stock, typically at the discretion of the bondholder. Companies prefer to offer convertible debt instruments with a later maturity date because it allows them more time to pay back the debt while investors prefer convertible debt instruments with earlier maturity dates because it decreases the risk of their investment. Issuers of convertible debt also need to consider the impact of conversion, which could be dilutive for existing shareholders.
