Revertible BondsBond Instruments
A revertible bond, also known as a reverse convertible or reversible, operates in a similar fashion to a convertible bond. A convertible bond is changed at your discretion if market price is higher than conversion price. A revertible bond automatically becomes a fixed ratio of stock if the market price falls below the conversion price. This price is set below the market price at issue.
Problem 1: Automatic Transformation
A Revertible bond sets you up for several problems. The first problem is automatic transformation. Convertible bonds change to shares if you choose to change them. Revertible bonds automatically convert if the share price drops below a certain threshold. You cannot choose whether or not this happens, the market price chooses for you. You will be switched from bonds to equity if the share price drops below a certain level.
Problem 2: Conversion on Collapse
The second problem is the condition of the conversion itself. The bond will convert if share price drops. Share prices drop if share issuers are financially undesirable, or investors believe they soon will become poor investments. When most investors exit equity investments in the firm, revertible bonds move you into equity investments by force.
Problem 3: Loss of Creditors Reimbursement Rights at Bankruptcy
You could argue that if a firm is collapsing, it is easier to unload equity than a defaulting bond. If you can convert and find a buyer when investors desire to sell shares, the conversion clause is useful. If you can’t you encounter a different problem: Equity holders are not guaranteed anything when firms enter bankruptcy. Bondholders are promised some percentage of assets recovered. Shareholders of a defaulting firm will sell their shares to avoid losing their entire investment. Share values will collapse, and the automatic conversion price will be triggered. Your bonds will become shares precisely when you don’t want them to, and you will be holding equities instead of bonds when reimbursements are paid to bondholders.
Problem 4: Asset Allocation
The fourth problem is conversions ruin asset allocation. A revertible bond takes you from bonds to equity, changing the percentage of your portfolio in either instrument. If you are attempting to maintain a specific ratio of bonds and equities, they will be disrupted by the forced conversion if share prices cross the automatic conversion threshold.
Problem 5: Rewards Bad Performance
The last problem is that the condition encourages bad performance. The revertible bond is an interest expense charge against the firm. When the firm gets into trouble and share prices tumble, bonds are converted into equity. A firm which issues a substantial amount of revertible bonds will have interest expenses removed as a reward for failing. In exchange they gain shareholders with trivial amount of control over the business.
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