What Is a Convertible Bond?

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Quick definition: Usually issued by companies, it’s a bond that pays interest but that can convert into shares of equity.

Why are we talking about this?

Convertible bond issuance is expected to hit roughly $120 billion in 2020, up 110% year-over-year, according to strategists at Barclays. That’s the highest amount in issuance since 2007, which saw just under $100 billion.

One reason for the massive issuance: companies this year, due to the coronavirus, needed to raise capital, but given the uncertainty, did not want to load up on debt. one way to mitigate the debt risk: issue bonds to raise fresh liquidity, but bonds that can turn into equity and relieve the company of the debt payments.

Usually, the bondholders exercise their option to convert the debt into equity when the company’s share price rises to a certain level.

It’s a harmonious relationship in which the company is incentivized to produce return for equity holders, as a higher share price will wipe some debt off of its books. Meanwhile, the bond holders enjoy some yield on their capital while they take the risk of financing the company and can enjoy solid returns as the company is freed of its debt. If the company’s share price doesn’t rise to a certain level, the bond holders continue collecting interest.

Of course, existing shareholder would see dilution to their shares when the bonds convert, but they also enjoy a capital raise for their struggling company.