Have you ever invested in a company that has convertible debt on its balance sheet? The intent of this post and the one I plan to share next week, God willing, is not to explain the accounting intricacies of convertible debt. Rather, I hope to offer something relevant to the theme of stock investments where the underlying company carries convertible debt on the balance sheet.

This week, I’ll attempt to offer a simple description of convertible debt and how it compares to “straight” debt. Next week, I plan to write on how the presence of convertible debt holders in a company can impact the investment position of the common stockholder.

Bonds are a common form of corporate debt. To describe convertible bonds, let me first establish the meaning of “straight” bonds. Straight bonds are issued by a company to the investment community in exchange for use of the investor’s money whereby the company using (borrowing) the money promises to repay the investor (lender) the principal on a specific future (maturity) date AND to pay regularly scheduled interest amounts until that maturity time. The investor in straight bonds has a right to recapture the principal and to receive the scheduled stream of interest payments.

With convertible debt, the company makes the same commitments to the bond investor as with straight debt. Additionally, though, the company grants an option to the bond holder to convert the bonds into a defined number of common stock shares. This establishes a “conversion price” for the stock share. If, for example, a conversion option provides that each $1,000 bond can be converted into 50 shares of common stock, the conversion price per common share is $20  ($1,000/50 shares = $20/share). For this conversion right, the bond holder (lender) is paid a lower rate of interest by the company relative to what straight debt would pay. This is because the conversion bond holder has more rights via this conversion option.

I’ll end this part on convertible bonds by saying that the company’s management who is contemplating issuing convertible debt vs. straight debt knows its present stockholders won’t desire to give “more rights” to the company lenders than what they normally provide. After all, any company lender has the rights to get paid interest before stockholders see any company profits, and to get paid back first in any potential bankruptcy proceedings (before stockholders receive a dime). So, giving these lenders the “additional” right to transfer standing from lender to owner, via conversion, is not attractive from the current stockholder’s vantage point. This means that the company issuing convertible debt probably is feeling some financial distress and not well-positioned to negotiate a straight debt deal.

If you want to read some more on the topic before my continuation next time, please go here.

May God bless you and keep you.