You didn’t think you’d see the exciting word “convertible” thrown between two nerd-words like “coupon” and “bond,” did you? Well, today’s your lucky day.
A zero-coupon convertible bond is a bond that features both a zero-coupon feature (which means it pays no interest) and a convertible feature (which means you could convert the bond into a common stock).
A zero-coupon bond may sounds ludicrous, but hear us out: it doesn’t give you interest, but you can buy it at a discount and get the face value once the bond matures. So yeah...that’s how money is made off of a zero-coupon bond. What a rebel compared to other bonds, right? It’s more or less wearing yellow Elton John glasses instead of the mainstream aviators, but it manages to somehow pull it off.
Meanwhile, convertible bonds are totally wearing aviators...the classic cool-kids. Convertible, in this case, means that the bond can be converted into a stock of the issuer. Which is cool for investors, because that means they can covert when the time is right, reaping gains when the issuer's stock goes up. Just like you can roll that convertible top down when the weather is nice.
Since zero-coupon convertible bonds are a cross between the safe-nerdness of the zero-coupon bonds and the cool-kidness of the convertible bonds, investors choose it to get the best of both worlds: lower risk with the option to convert if the price is right down the road.
Related or Semi-related Video
Finance: What is Convertible Debt?43 Views
finance a la shmoop. what is convertible debt? okay so we presume you
know what debt is. if not go uh you know watch that video. we'll wait actually no [man smiles at camera]
we won't wait. so convertible debt is just normal debt
but with one potentially highly valuable added feature. its convertible into
something else. well we were Marvel superheroes that would be our superpower.
you know finance man or something like that.
anyway example time. drone Ranger Inc needs money to upgrade a factory so that
it can produce drones that don't just fly, they swim too. like Aquaman. Alright well
prevailing interest rates for its level of risk and credit worthiness are 7%. the
company needs to raise a hundred million bucks, and the idea of paying seven [graph shown]
million dollars a year for that debt is just too high a price, so the CEO boss
says no .no new factory for you but if the company could get the debt cheaper
well then she might run bulk. unfortunately the company's stock trades
today at a very low multiple of earnings. only 15 times the dollar share they'll
earn this year. so I don't want to raise the hundred million dollars by selling
equity. it would be dilutive to do so, meaning that they would have to print
too many shares to raise that hundred million dollars, specifically a hundred [Dilution defined]
million divided by 15 or six and a half-ish million shares. well some of the
company's investors or rather all of them believe that the company's stock is
and or will be worth more per share than it is today at some point in the future.
otherwise they wouldn't own the stock today, right?
so the wily CFO of the company wonders if there's a Miley Cyrus style best of
both worlds solution here where you could sell equity at a higher price in
the future in part for a price decline on the cost of renting the debt. and in [Cyrus shown swinging across screen]
fact there is and yeah you guessed that it's called a convertible bond, or
convertible debt. yeah different kind of conversion there.
all right well the drone rangers stock is 15 bucks a share today but through
careful negotiated back-and-forth with capital markets people at an investment
bank, the company learns that there actually is demand for its debt price to
pay only 3% interest. if that debt is convertible into equity at 30 bucks a
share. so what does that mean? well if the stock stays under 30 bucks so pretty [definitions on screen]
much forever, then the buyers of the debt or the lenders of the money to the
company got taken. that is they only got three percent interest on their money
when they should have gotten seven percent for loaning money as debt to the
company. but if the stock takes off and the over water underwater drones really
you know fly off the shelves, then the convertibility feature of the
debt will be exercised or used which would be a good thing. so the debt is
convertible at 30 bucks a share which means that a hundred million dollars
raised would cause the company to be diluted a hundred billion divided by 30
bucks, or you know 3.3 ish million shares, I eat it's half the dilution it would [equations]
have been at the company just sold shares at 15 bucks each.
it essentially wrote a call option to the buyers of the debt to be able to
call or buy its stock for 30 bucks a share or 30 times the current year's
earnings at some point you know whenever in the future. like being diluted at 30
times earnings is way less painful than being diluted at 15 times.
so yeah that's convertible debt in a nutshell. not what you find yourself in
during your midlife crisis when you desperately feel the urge to buy a [woman races by in sports car]
silver Beamer that cost three times our annual salary yeah. been there it was a
nice Beamer
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