Chartered Institute of Stockbrokers (CISI) Professional Practice Exam

What is the primary advantage of a company issuing a convertible bond?

1. It guarantees higher returns for investors

2. It allows for fixed interest payments

3. It can be a cheaper source of finance

4. It avoids diluting existing shares

The correct answer is: It can be a cheaper source of finance

The primary advantage of a company issuing a convertible bond lies in its potential to be a cheaper source of finance. Convertible bonds typically offer lower interest rates compared to standard bonds because they come with the advantageous option for bondholders to convert their bonds into shares of the company's stock at a predetermined price. This conversion feature adds value for investors, as it provides them with upside potential if the company's stock performs well. Consequently, companies can attract investors by offering the possibility of equity participation while keeping borrowing costs down. Additionally, by using convertible bonds, a company can defer the dilution of existing shares until bondholders decide to convert their holdings into equity. Until that conversion happens, the company benefits from lower interest expenses, making this type of financing more economical compared to traditional debt or issuing new shares outright. This flexibility can be particularly beneficial for growing companies looking to manage their capital structure efficiently.