Bonds are a means of acquiring finance for the issuer and a means of earning income for the investor. Different provisions in the contract outline the obligations of the issuer to the bondholder and may extend certain special rights to the bondholder or the issuer. Knowing the features of the bond can help investors better assess the risks and rewards of investing in debt securities. For example, corporate bonds may be convertible or callable or both.
Convertible bonds contain a provision that allows the bondholder to convert the bond into shares of the corporation's common stock. Generally, the stock price has to increase significantly before conversion would benefit the bondholder. Owning a convertible bond means the bondholder owns a bond and a stock option. Because of the added feature, convertible bonds generally sell at a higher price than nonconvertible bonds of comparable risk. Convertible bonds also may have a call provision. This allows the issuer to force redemption of the bond should the stock price increase dramatically, and therefore a call provision on a convertible bond limits the profit investors can earn.
A corporation might issue a $1,000 par value bond with a conversion provision that states the bondholder can trade the bond back to the issuer for 50 shares of the company's common stock. Suppose a share of the issuer's common stock has a current market value of $10. The current conversion value of the bond, which is the worth if the convertible bond is converted to common stock, would be $500, disregarding stock dividends and bond interest. Obviously, the investor would not consider conversion. However, suppose the stock price increases to $25 per share. The conversion value of the $1,000 par value bond would be $1,250. Based on this value, after comparing stock dividends and bond interest, the investor may decide to convert the bond for shares of stock.
Callable bonds contain the characteristics of a noncallable bond with a call option that belongs to the issuer. The more interest rates decline, the more valuable the call option becomes to the issuer. Callable bonds generally offer investors a higher interest rate than comparable bonds without call provisions. This higher yield on the bond entices investors to accept the callable feature. One significant reason investors would choose a noncallable bond over a callable one is that it is understood a call provision will limit price appreciation.
Bonds are issued with a call provision for several reasons. First, if interest rates decrease, the call feature allows the issuer to call the bond and issue new debt at lower rates. Second, the bond may carry a provision, known as a sinking fund, that requires the issuer to pay off the bond progressively over time instead of in one lump sum at maturity. The terms of the sinking fund may specify that a percentage of the issue or a fixed amount must be retired before maturity. In addition, covenants of the bond may restrict the corporation from undertaking some activity management thinks would be profitable -- for example, expansion for which new financing in needed. The bond covenant may restrict taking on new debt. Thus, the issue would need to be called in order to seek new financing.
- Investment Analysis and Portfolio Management; Frank K. Reilly and Keith C. Brown
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