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Risk of Convertible Bonds, Purchase and Sale
Risk of Convertible Bonds
As with any debt security, the risk of default is what most worries. This is specially true with convertible bonds because they are subordinated to other debt issues from the issuing company. Consequently, convertible bonds are not as safe as the company’s senior debt and before an eventual bankruptcy. Convertible bondholders are after the bondholders in the collection line. That?s why convertible bondholders could only receive in the best case a fraction of principal invested.
As with any debt security, the risk of default is what most worries. This is specially true with convertible bonds because they are subordinated to other debt issues from the issuing company. Consequently, convertible bonds are not as safe as the company’s senior debt and before an eventual bankruptcy. Convertible bondholders are after the bondholders in the collection line. That?s why convertible bondholders could only receive in the best case a fraction of principal invested.
Convertible bonds are affected by the interest rate risk. Convertible bonds are fixed-income securities with coupon rates that tend to be lower than those in conventional debt issues. Consequently, an increase in the market’s rate of interest causes a greater decline in prices of issues of convertibles than of non-convertible bonds.
Generally, the high rates of interest tend to depreciate prices in the stock market, and a convertible bond is doubly cursed if stock prices of the issuing company are depressed. Prices of stock and stock markets can be both, uncertain and volatile, which does not assure the appreciation of the convertible.
Just as well, there is a risk that the stock price will not increase over the conversion value, the convertible bond will not be converted, and the convertible bondholder will receive a smaller return during the bonds lifetime than it would from other conventional bonds.
This low return is due to lower coupon yields in convertible bonds than those of comparable nonconvertible bonds. Most convertible bonds have call provisions therefore there will always be a risk of call.
Corporations could call in bond issues when rates of interest drop to issue new bonds with lower coupon rates so as to safe money.