Convertible bonds give the holder the option to convert the bond into another security. This may be debt or share capital of the issuer company or of a guarantor. Most commonly the conversion is to equity.
The option allows the holder to subscribe for debt or equity in the issuer company. The bond is surrendered in return for the new issue, share etc.
A bond with an option to convert will be treated differently from an accounting and taxation perspective (being a potential share). Generally, its interest rates would be lower to reflect the value of the option.
Commonly the principal amount of the bond is applied to subscribing for the new shares or bond / debt at the conversion price. If the bond is in a currency different to that of the other security, the exchange rate may be fixed.
The benefit of the convertible instrument is that lending is available at a lower rate to reflect the value of the option. There may be a longer maturity or other more favourable terms than would otherwise be available. Wider sources of funds may be available as institutions may be entitled to treat the instruments as equity rather than debt. On conversion, the debt is automatically reduced, and equity increased so that gearing improves.
If the issuer has the right to redeem, the right to convert ends on redemption. The issuer may retain the right to redeem the shares. It may be only exercisable after certain periods and then only at premium which reduces. The issuer may be required to give longer notice of redemption to allow the bondholder the right to convert prior to redemption.
The holders of the convertible shares may wish to secure that they are not diluted. There may be prohibitions on dilution or automatic adjustments in the conversion price. There may be a right for the conversion to be accelerated before the dilution happens.
The terms of conversion will be specified. Conversion may take place for example,
- if shares are issued at less than current value
- shares are granted with rights or options to convert at less than the current market
- capital distribution to shareholders;
- modification of share rights of conversion
There may be restrictions on the extent of dividends which may be made. Excess dividends would dilute the conversion and could effectively subdivide shares. There may be provision restricting transfer of assets or other stripping of value.
In certain cases, the option holders will require the right to exercise the option early prior to the standard exercise event. This may occur in relation takeovers, amalgamations and reconstructions. If the market price exceeds the conversion price, the options may be exercised.
A warrant is a separate instrument of a bond and gives the holder the right to subscribe for debt or equity. Warrants may be detached from the bond and traded separately. Warrants may be in negotiable form and passed by delivery.
Warrants attached to bonds are similar to convertible bonds. The same broad principles as above apply. A bond with a warrant should be cheaper, all things being equal and give the possibility of taking advantage of rise in the share price.
The warrant is generally exercisable up to the redemption of the bond. On exercise of the warrant, the designated price is payable. Shares are issued. The issuer may use the proceeds to redeem the bonds which has the same effect as the convertible bond. The same broad protective principles are likely to apply as mentioned above.
A debt warrant is an option to subscribe for new bonds. The subscription price and return will be specified. A person who holds a warrant will gain if there is a fall in general interest rates.