What are convertible bonds and why are they needed: an explanation in human language

Investments

03.08.2020

14293

Author: Igor Smirnov

Photo: pixabay.com

Bonds are securities that give the right to receive income from the entity that issued them. Bonds may be resold on the secondary market.

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To explain what a bond is in simple words, you can do this:

• Bonds are receipts with an obligation to pay a certain amount on a specified date.
• The amount payable on bonds is greater than the amount spent to purchase them.
• Bonds can be resold, in this case the person obligated to pay does not change, but the recipient of the funds changes.

To better understand the place of bonds, you can compare them with shares of enterprises:

Photo: pixabay.com

Bonds: what are they?

Bonds are a type of securities that represent debt obligations of the state or individual enterprises.

IMPORTANT!

The principle of their operation is similar to bank deposits: you spend 500 rubles to purchase a security, and after a certain period of time you get 500 rubles back. with a fixed percentage.

All conditions - cost, size and frequency of interest payments, as well as terms - are agreed upon upon purchase. The ability to estimate your benefit in advance is what makes a bond different from other securities.

They are traded on the stock market, and their value can either increase or decrease. The value is influenced by the international situation, the policy of the Central Bank, as well as changes in the company.

In the modern world, almost all securities are issued in electronic form. After purchasing bonds, a certain entry is made on the stock exchange, and only a line with his name and the number of assets purchased is available to the buyer.

Taking this circumstance into account, when choosing bonds it is necessary to take into account not only the yield and term, but also the reputation of the company that issued them. In the event of bankruptcy, the bondholder will lose the invested funds.

ATTENTION!

A company's solvency is determined by a credit rating agency.

To understand the profitability mechanism, you need to know the main characteristics of these assets:

1. Nominal cost. A fixed amount paid to the holder when the bond matures.
2. Market price. The effective cost of acquiring a security. It is influenced by many factors, and therefore it may change. The value of the bond is determined at auction and is called the “net price of the bond.”
3. Maturity. Reflects the predetermined period of validity of the asset as a result of which the owner receives its nominal value.
4. Coupon. Interim interest transferred by the issuer in favor of the bond investor at a certain frequency (monthly, quarterly, annually). These payments generate stable passive income for a long time.
5. Yield to maturity. The main parameter showing the investor's income if he holds the bond until maturity.

Who issues bonds?

Bonds can be issued by the following structures:

1. State and municipal authorities. Government bonds in the Russian Federation are issued by the Ministry of Finance to solve certain problems and finance local projects.
2. Commercial companies. The issue is carried out in order to attract additional investment in the business. Bonds of solvent issuers with high ratings on the securities market are usually called the 1st echelon (“blue chips”), with less reliability - the 2nd and 3rd echelons.
3. Banking institutions. Papers are almost no different from commercial ones. But the buyer needs to take into account that banks determine different levels of repayment priority for investors. If the priority and quality of collateral is low, the risk for the investor increases.

Active trading

There are situations in the market when the value of a security decreases significantly for no apparent reason. Of course, there are reasons, for example, a large investor dumps a large package of bonds. Or there was unpleasant, but not critical news about the issuer.

As a result, you can observe a drop in quotes by several percent. As a rule, the price returns to its previous level after 1-2 weeks. And by buying securities 3-5% cheaper as a result of the decline, you can make money on the subsequent increase in quotes.

And don’t forget about the NKD, which will provide additional profit during the holding of the securities.

How to make money on them?

The buyer becomes familiar with the profitability of the bond upon purchase. The security has a coupon payment schedule. In addition, it is not necessary to wait for the paper to expire; you can sell it at any stage. The price of a bond will be influenced by the current economic situation, in which there is a chance of both making money and incurring losses.

In 2022, earnings on Russian Government Bonds range from approximately 5 to 11% per annum, on securities of small commercial companies up to 18%.

Attention! When the yield is high, the price of the bond is usually low.

Differences between bonds and stocks

Stocks and bonds are classified as securities, but have fundamental differences from each other.

A share is a security that certifies part of the ownership of its shareholder in a company and gives him the right to participate in the management of the enterprise and receive dividends.

A bond is a debt obligation of a company to an investor, which does not provide for a share in the company and participation in its management.

Main differences:

1. Payments. Shareholders are paid dividends, and bondholders receive income in the form of coupons at specified intervals.
2. Regularity of payments. Share dividends are paid once a year, and the regularity of bond payments occurs monthly, quarterly or annually. The frequency of payments does not change throughout the entire term of the bonds.
3. Amount of payments. The return on a stock is influenced by the financial success of the company. The interest on bonds is fixed in the issue documents.
4. Price. The price of shares corresponds to the performance of the company, and therefore can rise and fall. The value of a bond is determined by its face value.
5. Risks and guarantees of payments. Shareholders are not guaranteed a refund of their invested money. Bond investors can expect a return of the face value and a return on coupons.
6. Deadlines. A share is a perpetual security that is valid until the liquidation of the company. The bond is issued for a period specified in the issue documents.

ATTENTION!

Bonds are a more conservative type of securities. The risks when buying bonds of large companies are minimal, but the shares of these concerns can both rise in price and fall.

Types of bonds

Bonds are divided into many types, let's look at the main ones.

According to the form of income payment

• Coupon (interest) bonds. Provide for the payment of interest on the face value - coupon redemption. For some securities there is only one payment, for others - several. Most coupon bonds are issued with a specific interest rate. However, there is a floating rate when payments change due to reference to macroeconomic figures or stock market conditions.

• Discount bonds. The nominal cost of acquiring these assets is lower, but they are repaid according to their nominal value.

Discount is the difference between the posted price and the nominal value.

IMPORTANT!

If the full price of a bond is 1,000 rubles, and you bought it at a discount for 700 rubles, at maturity you will receive 1,000 rubles. - its entire face value.

By maturity

Depending on the term, the following types of bonds are distinguished:

• short-term - from several months to 1 year;
• medium-term - from 1 year to 5 years;
• long-term - over 5 years;
• perpetual - do not have a specific validity period, but can be bought back by the issuer on pre-agreed conditions;
• Other possible combinations of these options are provided.

By issue currency

The issue of bonds can be carried out by the issuer in ruble and foreign currency equivalent.

By issuer

Depending on the initiator of the debt issue, several types of bonds are distinguished.

State

The coupon rate is affected by the Central Bank rates.

Government bonds are issued for several reasons, here are some of them:

• finance the budget deficit;
• raise money for government programs in the field of housing improvement, social security and other tasks;
• regulate economic activities: money supply in circulation, impact on inflation, economic growth.

ATTENTION!

The most reliable debt obligations are OFZ (federal loan bonds). Coupons for them are not subject to personal income tax.

Regional and municipal

The issue is used to fund local projects. The average coupon for them is approximately 8% per annum, and the reliability is high: if the entity encounters difficulties, the state can pay off the debt. The liquidity of these assets is low.

Corporate

They are produced by commercial companies to attract financial resources from private investors. Coupon rates range from approximately 4 to 12% per annum, and when choosing, you should weigh the risk and solvency of the issuer.

Eurobonds

Debt securities denominated in foreign currency. Interest rates on them range from 4 to 6% per annum in US currency and approximately 3% in euros.

Commercial

Sometimes private firms post this special type of paper. Distribution takes place in a targeted manner and by closed subscription. You won't be able to buy them on the stock exchange.

By convertibility

If it is possible to exchange them for other securities, there are:

1. Convertible bonds. They give the right to exchange for other assets of the enterprise, for example, shares.
2. Non-convertible bonds. Simple bonds that do not give the right to exchange them.

IMPORTANT!

In accordance with Russian legislation, bonds may be converted into bonds with other characteristics, into ordinary or preferred shares.

By security

According to this parameter, bonds can be of the following types.

Secured

Investment safety can be ensured by:

1. Collateral in the form of real estate, company equipment and other assets. If the issuer goes bankrupt, the investor will take back—sell—the collateral and recoup the money spent.
2. Guarantee from a third party. If the issuer goes bankrupt, this guarantor will assume the obligations under the promissory notes.
3. State or municipal guarantee. Similar to a guarantee, but in this situation the debts on the securities will be transferred to the bank, local or federal budget.

Unsecured

When a company goes bankrupt, security holders wait until the bankruptcy process is completed. Further, their claims are satisfied in a regulated manner along with other creditors of the enterprise.

ATTENTION!

The return of the full amount of invested funds is not guaranteed.

Unsecured (subordinated)

In the event of bankruptcy of the enterprise, the investor can return the invested money to the last one after paying the creditors. By this point, funds may no longer be enough. In addition, if the company has not yet gone bankrupt, but has only reached the point of reorganization, unsecured bonds are written off to zero. Here their owner will not receive payments.

By method of circulation

Bonds are:

• with free circulation - there are no restrictions on the acquisition and sale of these bonds. Transfer from one owner to another is allowed;
• with limited circulation - the acquisition and sale of these bonds are limited. They are not allowed to be sold during a certain period, or the issuer sets limits on the value of the securities.

Examples of convertible bonds in Russia, Europe and the USA

In the domestic stock market, convertible bonds are not as common as in Western countries and the United States. However, in general, Russian legislation contains all the necessary norms, so many are already issuing in them to attract investment.

For example, in December 2013, Yandex issued $600 million in convertible bonds at an interest rate of 1.125%.

The American financial holding JP Morgan did not hesitate to issue $7.3 million.

Until recently, one of the most “tasty” offers on the European stock market were the securities of Deutsche Bank AG. Issued in the amount of $2.7 million at an annual rate of 12.39%. Denomination - 1000 euros, maturity date - June 25, 2022.

Bond income

The bondholder's income consists of coupon payments and the difference between the purchase price of the bond and the redemption price (discount income).

Types of profitability:

1. Coupon. Reflects the percentage of the security's face value that the issuer will pay you. You can view it on the exchange website. Find the required bond using the search engine and you will be taken to the bond page.
2. Current. It contains the size of the coupon rate and the real cost of purchasing the bond on the exchange. A useful indicator if you are purchasing a commitment for a term of less than a year and intend to sell it well before the expiration date.
3. Simple yield to maturity. Takes into account not only the income from coupons with a real price, but also the planned redemption cost. It is necessary if you do not intend to sell the bond for a long time, but want to receive coupon income.
4. Effective yield to maturity. The most meaningful indicator of the return on an asset, representing the total income of the investor, taking into account the reinvestment of coupons. Such profitability can be achieved by leaving all coupon payments in the brokerage account and additionally purchasing securities with identical coupons with them.

The 2nd, 3rd and 4th types of yield can be calculated using a bond calculator posted on the exchange website.

If an investor wants to make extra money on bonds, they can take advantage of rising quotes. Each bond has a face value, which the issuer will return to you upon completion. However, the market price of these securities is constantly changing, and if the value of the bond has increased, then it can be sold at a profit and without waiting for the maturity date.

ATTENTION!

When calculating bond yields, take into account broker fees and taxes, which reduce the final yield.

Correctness of calculations

Calculations using the bond yield to maturity formula can be verified. How to do it?

Substitute the resulting yield value into the formula. Skip the element P whose value you know for sure. Accordingly, in the verification formula you need to calculate P (the price at which you purchased the bond). This is done like this:

P= C x ((1-(1/(1 + i)^n))/i)+M/((1+i)^n).

Let's imagine the elements of the formula:

• P is the amount of money you paid for the bond.
• C—coupon payments.
• i is the yield of this bond to its maturity.
• n is the total number of coupon payments made.
• M is the nominal price of the bond.

In most cases, the calculation will give you a value slightly different from the amount you paid for the bond. This confirms the statement that it is only possible to calculate the bond’s yield to maturity using the formula only approximately. If the result obtained does not suit you at all, then you can turn to calculating the bond’s yield in special investment calculators presented on Internet resources.

What risks might a bond owner face?

Investing always involves certain risks:

1. Risk of default. If the issuing company declares itself bankrupt and cannot keep its financial promises to investors. The exception is covered bonds - they are not subject to risk.
2. Risk of restructuring of liabilities. The danger of changing the terms of securities. A meeting of owners of bond assets has the right to make such a decision at the request of the issuer.
3. Liquidity risk. The chance that an investor will not be able to promptly sell debt notes at fair value if they wish to do so before their expiration date. This happens if the issuer has financial difficulties or the company is little known.
4. Interest rate risk. It consists of increasing the average market rate on identical bonds. If the interest rate on an investor's bonds is lower than the market rate, his income will be lower. This type of risk strongly depends on the key rate of the Central Bank.

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How to reduce all risks to a minimum?

Risks and returns are interrelated. An investor will not receive much income when buying bonds with minimal risks - this is the law of the market.

The most reliable and stable are government debt receipts, in particular OFZs issued by the Ministry of Finance.

The assets of large concerns with a high credit rating and an average level of profitability are considered slightly less reliable.

You can experiment and buy income bonds with an average “B” rating. However, the investor must consider the risk of default, debt restructuring and liquidity.

IMPORTANT!

Before buying bonds, you should definitely analyze the reliability of the issuing company. Read the news and study available accounting and financial documentation - this information is publicly available on the websites of the fund and news agencies.

Pros and cons of bonds

Advantages:

1. Transparency. The profitability is known in advance, or it can be easily calculated automatically.
2. Minimal risk. It is present, but its value is lower than when purchasing other securities.
3. Sale. The price of these assets does not change much, and they can be sold at a value close to their face value.
4. No tax. The yield of certain types of bonds is not subject to taxation.

Flaws:

1. No insurance. Investments on the stock exchange do not participate in the insurance system.

Where can I buy

You can purchase individual convertible bonds through your broker. In addition, a number of large stock companies offer thematic mutual funds.

The largest:

• Calamos Convertible A (ticker CCVIX);
• Fidelity Convertible Securities (FCVSX);
• Vanguard Convertible Securities (VCVSX);
• Franklin Convertible Securities (FISCX).

It is possible to choose exchange-traded funds ETF (for example, SPDR Barclays Capital Convertible Bond ETF).

Best brokers

To choose a broker, look at his reputation, as well as the spreads, commissions and special conditions he can offer you.

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