convertible bond In finance, a convertible note (or, if it has a maturity of greater than 10 years, a convertible debenture) is a type of bond that the holder can convert into shares of common stock in the issuing company or cash of equal value, at an agreed-upon price. It is a hybrid security with debt- and equity-like features. Although it typically has a low coupon rate, the instrument carries additional value through the option to convert the bond to stock, and thereby participate in further growth in the company's equity value. The investor receives the potential upside of conversion into equity while protecting downside with cash flow from the coupon payments. From the issuer's perspective, the key benefit of raising money by selling convertible bonds is a reduced cash interest payment. The advantage for companies of issuing convertible bonds is that, if the bonds are converted to stocks, companies' debt vanishes. However, in exchange for the benefit of reduced interest payments, the value of shareholder's equity is reduced due to the stock dilution expected when bondholders convert their bonds into new shares. The convertible bond markets in the United States and Japan are of primary global importance. These two domestic markets are the largest in terms of market capitalisation. Other domestic convertible bond markets are often illiquid, and pricing is frequently non-standardised.[citation needed] USA: It is a highly liquid market compared to other domestic markets. Domestic investors have tended to be most active within US convertibles Japan: In Japan, the convertible bond market is more regulated than other markets. It consists of a large number of small issuers. Europe: convertible bonds have become an increasingly important source of finance for firms in Europe. compared to other global markets, European convertible bonds tend to be of high credit quality. Asia (ex Japan): The Asia region provides a wide range of choice for an investor. The maturity of Asian convertible bond markets vary widely. canada: canadian convertible bonds are exchange traded. Most of the canadian convertible bond market consists of unsecured sub-investment grade bonds with high yields that are reflective of the issuer's risk of default.[1] Domestics versus Euroconvertible bonds A further important classification is between the domestic and euroconvertibles markets. Euroconvertibles pay their interest gross and are free of transfer duty when bought, and are delivered into Euroclear or clearstream for 7 day settlement. Domestics may have different settlement dates, they may pay their interest net of tax and be subject to transaction taxes. European euroconvertibles are generally highly liquid and have a pan-European investor base, dominated by hedge funds and proprietary desks. European domestic convertibles (such as in the UK and Italy) are dominated more by local investment institutions. Since the early nineteen-eighties, foreigners have been able to receive interest on U.S. domestic convertible bonds gross, and this has broadened the global investor base to embrace global hedge funds and other global investors. Likewise, foreigners have been able to receive interest gross on French convertibles (obligations convertibles or Ocs), further blurring the differentiation between the domestic and euro cB markets. The pan-European cB market has substantially replaced the various domestic cB markets, and the driver behind this has been the ability of cross-border investors to receive interest payments gross. Structure and features Like any typical bond, convertible bonds have an issue size, issue date, maturity date, maturity value, face value and coupon. They also have the following additional features: conversion price: The nominal price per share at which conversion takes place. conversion ratio: The number of shares each convertible bond converts into. It may be expressed per bond or on a per centum (per 100) basis. Parity (conversion) value: Equity price × conversion ratio. conversion premium: Represent the divergence of the market value of the cB compared to that of the parity value. call features: The ability of the issuer (on some bonds) to call a bond early for redemption, sometimes subject to certain share price performance. The intention is to encourage investors to convert early into equity (which has now become worth more than the bond's face value), by threatening repayment in cash for what is now a lower amount. Types There are many variations of the basic structure of a convertible bond. Vanilla convertible bonds are bonds which may be converted at the option of the owner into the shares of the issuer, usually at a pre-determined rate. They may or may not be redeemable by the issuer prior to the final maturity date, subject to certain share price performance conditions. Exchangeables (XB) are bonds which may be exchanged into shares other than those of the issuer. Strictly speaking, they are not convertibles, but they share certain common evaluation characteristics. Mandatory convertibles are short duration securities²generally with yields higher than found on the underlying common shares ² that are mandatorily convertible upon maturity into a fixed number of common shares. If it is intended to provide a minimum value for the convertible at maturity, convertibility may be into a sufficient number of shares based on the stock price at maturity to provide that minimum redemption value. Mandatory exchangeables are short duration securities²generally with yields higher than found on the underlying common shares ² that are mandatorily exchangeable upon maturity into a fixed number of common shares. Likewise, if it is intended to provide a minimum value for the convertible at maturity, exchange may be into a sufficient number of shares (based on the stock price at maturity) to provide that minimum redemption value. Such exchangeables may be said to be "redeemed into equity", and care should be taken when reading the offering documentation, lest "redemption" and "conversion" are confused. Contingent convertibles (co-co) only allow the investor to convert into stock if the price of the stock is a certain percentage above the conversion price. For example, a contingent convertible with a $10 stock price at issue, 30% conversion premium and a contingent conversion trigger of 120%, can be converted (at $13) only if the stock trades above $15.60 ($13 x 120%) over a specified period, often 20 out of 30 days before the end of the quarter. The co-co feature was often favored by issuers because the shares of underlying common stock were only required to be included in diluted EPS calculation if the issuer's stock traded above the contingent conversion price. In contrast, non-co-co convertible bonds result in an immediate increase in diluted shares outstanding, thereby reducing the EPS. The impact to diluted shares outstanding is calculated using the "as- if-converted" method, which requires the most conservative EPS value be used. Recent changes to GAAP have eliminated the favorable treatment of co-co's, and as a result their popularity with issuers has waned. OCEANEs (or Obligation convertible En Actions Nouvelles ou Existantes) are bonds which may be converted into the equity of the issuer, but the issuer has the right to deliver new shares or old shares held in Treasury (possibly with different dividend rights). They are a common structure for French issues. These bonds are technically not convertibles, as defined by the law of 25 February 1953. consequently, there is no three-month conversion period for investors following the date that bonds called are due for redemption, (as is otherwise required, under French law, for French convertibles). Convertible preferred stock, (convertible preference shares in the UK), is similar in valuation to a bond, but with lower seniority in the capital structure. Non-payment of income is generally not regarded as an act of default by the issuer. The terms of each issue will define whether or not entitlement to unpaid preference income is cumulative. Main article: convertible preferred stock SPV structures Many convertibles, particularly Euroconvertibles, are issued though special purpose vehicles (SPVs), (typically a subsidiary based offshore in British Virgin Islands, the cayman Islands or Jersey). The SPV debt is convertible (exchangeable to be more precise) into the equity of the parent company, which is often a holding company. Although the parent may guarantee the SPV debt on an unsubordinated basis, the assets of a parent company could just be shares of various subsidiaries. This means that nominally unsubordinated guarantee on the debt could in fact be structurally subordinated. More significantly, the basis of seniority upon which money raised by the issuing entity has been onwardly applied is rarely revealed at issue; if on-lent on a subordinated basis, the asset quality of the issuing entity and its debt is impaired. This creates a fundamental weakness in the credit analysis of any convertible and non-convertible SPV debt. Reverse convertible securities are short-term coupon-bearing notes, structured to provide enhanced yield while participating in certain equity- like risks. Reverse convertibles securities are most commonly targeted towards the US market. Their investment value is derived from underlying equity exposure, which is paid in the form of fixed coupons. Generally speaking, the higher the coupon payment, the more likely it is that the investor is delivered shares on maturity. Investors receive full principal back at maturity (plus accrued interest) in cash (but no more) if the Knock-in Level is not breached at any time during the life of the security. The Knock-in level is typically 70-80% of the initial reference price. The underlying stock, index or basket of equities is defined as Reference Shares. In most cases, Reverse convertibles are linked to a single stock. Main article: Reverse convertible securities Going-public bonds are fixed interest securities which convert or exchange into shares of a company when it later achieves a stock market listing.