What is a conditional put convertible bond?
A conditional put convertible bond is a special kind of bond. It’s a bond that can change into something else – stock shares in the company that gave out the bond. That’s why it’s called a “convertible” bond.
The “conditional put” part means the person who owns the bond can choose to sell it back to the company under certain conditions. Usually, this happens if the price of the company’s stock reaches a certain level that the bond owner and the company agree on beforehand.
How do these bonds work?
Okay, so imagine a big company needs to borrow money. They could go to a bank for a loan, but they decide to get the money differently. They give out these special bonds instead.
People can buy these bonds, and the company promises to pay them back later with interest. That interest is usually a fixed amount paid every year. The bond owners are lending their money to the company.
But here’s the unique part. The bond owners have a choice. When the bond ends, the owners can trade in their bonds and get stock shares in the company instead of getting their original money back.
The “put” option
Now, the bond owners have another choice with a conditional put convertible bond. They can “put” the bond back to the company and get their money back early. But they can only do this under certain conditions that the company and the bond owners agree on.
Usually, the condition is linked to how well the company’s stock is doing. If the stock price goes below a certain level, the bond owners can use their “put option.” They hand their bond back to the company and the company has to give them their money back right away instead of waiting until the bond’s end date.
Why companies use these bonds
Companies like giving out these bonds for a few reasons. First, the interest they have to pay on the bonds is usually lower than the interest on regular loans. That’s because the bond owners have the choice to trade their bonds for stock later. The chance to own stock in the company is like a bonus that makes up for the lower interest.
Second, if the company’s stock does really well, the bond owners will probably choose to convert their bonds to stock. Then the company won’t have to pay back the bond money at all! The loans basically disappear when the bonds convert to stocks.
Risks for bond owners
But there are risks for the bond owners. If the company’s stock price doesn’t go up like they hope, their bonds might not be worth as much as they thought. And if the stock price goes way down, the company might be in trouble. Then even if the bond owners use their put option to get their original money back, the company might not have the cash to pay them.
A famous example
One big story about these bonds happened with a company called Enron. Enron gave out a lot of convertible bonds with a put option. But Enron was hiding financial problems, and when the truth came out, its stock price crashed.
The bond owners tried to use their put options to get their money back, but Enron didn’t have the cash. Enron ended up going bankrupt and the bond owners lost a lot of money. It was a big scandal.
How they’re different from regular convertible bonds
Conditional put convertible bonds are different from regular convertible bonds in a couple ways. With regular convertible bonds, the bond owners can only choose to convert their bonds to stock at certain times or dates. And they don’t have the extra choice to “put” the bond back and get their original money returned early.
The put option is like an extra safety net for the bond owners. It gives them a way to get out early if things aren’t going well with the company’s stock.
Why investors might like them
Some investors like these bonds because they offer the chance to make money in different ways. The investors get interest payments as long as they hold the bonds. That’s a steady income stream.
And if the company’s stock goes up a lot, the investors can trade in their bonds for stock and possibly make even more money. The stock price just has to go up enough to make up for the lower interest they got on the bonds compared to regular bonds.
But if the stock doesn’t do well, the investors have the put option as a backup plan. They should be able to get their original money back instead of being stuck with stock that isn’t worth much.
The fine print
Of course, there’s always some fine print to watch out for. The exact conditions for using the put option can be complex. And there might be certain times when the bond owners aren’t allowed to convert to stock or use the put option.
Plus, if a whole lot of bond owners try to use their put options at the same time, the company might have trouble coming up with the cash to pay them all back at once. That could put the company in a tough spot financially.
How popular are they?
Conditional put convertible bonds aren’t super common, but they’re not rare either. Usually it’s medium to large companies that give them out. The companies are often in fast-growing fields like technology or healthcare, where investors hope the stock price will go up a lot.
But because of the Enron scandal and some other cases where investors got burned, some people are wary of these bonds. They really have to trust the company’s finances and future prospects to invest in them.
An example deal
Here’s one way a conditional put convertible bond might work. Imagine a company issues 5-year bonds that pay 3% interest annually. The conversion price is set at $50, which is a 25% premium to the current stock price of $40.
The bond owners can choose to convert their bonds to stock any time after year 2. And they have a put option to sell the bonds back to the company at face value plus accrued interest after 3 years if the stock price falls below $35.
So if the company’s stock soars above $50 after 2 years, the bond owners would likely convert to stock. But if the stock crashes below $35 after 3 years, they could use the put option to get their money back instead.
