Convertible bonds are typically issued by companies that have high expectations for growth and less-than-stellar credit ratings. The companies get access to money for expansion at a lower cost than they would have to pay for conventional bonds. Investors, in turn, get the flexibility of turning their convertible bonds into cash or stock shares.

A startup company with little current revenue and rapid growth potential might be an ideal candidate for issuing a convertible bond.

Understanding Convertible Bonds

A convertible bond is a hybrid security that has some features of both a bond and a stock share. It pays interest at a set rate at specified intervals. But, it can be converted to either cash or a specified number of common shares when it matures. The conversion option is available at pre-set times during the life of the bond.

Convertible bonds generally have a lower rate of return than conventional bonds. They appeal to investors who like the option of exploiting an increase in the stock's price or taking the cash, depending on which is the better deal when the bond matures.

Key Takeaways

  • A convertible bond is a hybrid security that offers investors the option to cash it in at the end of its term or convert it to shares in the company.
  • Convertible bonds offer lower interest rates than comparable conventional bonds, so they're a cost-effective way for the company to raise money.
  • Their conversion to shares also saves the company cash, although it risks diluting the share price.

The terms of the bond establish its conversion ratio. That is, the bond may be convertible to four or five shares of the company's common stock. That would be a conversion ratio of 4:1 or 5:1.

Convertible bonds are an appealing option for corporations as well. They can set the rates of return a bit lower than conventional bonds. And, when the convertible bonds mature, some of them will be repaid in stock rather than cash.

There's yet another bonus for the company: The interest on convertible bonds is tax-deductible.

The Drawback of Convertible Bonds

Corporations like convertible bonds because they lower their cost of capital. It's a cheap way to borrow money to improve the business.

Tesla's Gigafactory was built with money raised in a convertible bond issue.

Nevertheless, there is a drawback. If many or most of the convertible bond holders convert to stock shares, the company's shares in the market will be diluted. And that reduces the shareholders' equity value.

Clearly, a company can over-do convertible bonds.

The Tesla Example

Convertible bonds are typically issued by firms with substandard credit ratings and high expected growth. For example, in 2014, Tesla Motors issued $2 billion in convertible bonds to finance the construction of the Tesla Gigafactory in Nevada.

Tesla had reported low or negative earnings over the few years leading up to 2014. Raising capital for the project using standard bonds would have been prohibitively expensive as investors would have demanded steep interest rates in return.

With the conversion option, the interest rates on Tesla's convertible bonds ranged from 0.25% to 1.25%.

By mid-2020, the first section of the Tesla Gigafactory was up and running in the Nevada desert.