What is the definition of options attached to bonds?

Answer 1

In the context of corporate bonds, a bond is a debt investment in which an investor loans money to a company that borrows the funds for a defined period of time at a fixed interest rate. Bonds are used by companies to finance a variety of projects and activities. Bonds are commonly referred to as fixed-income securities and are one of the three main asset classes, along with stocks and cash equivalents..

The indebted entity (issuer) issues a bond that states the interest rate (coupon) that will be paid and when the loaned funds (bond principal) are to be returned (maturity date). Interest on bonds is usually paid every six months (semi-annually). So if the coupon is 6% and the bond has a maturity period of 10 yrs, the bond investor will receive interest at 6% p.a. every six months until the end of the 10 yrs when he will get his principal back.

A slightly more complicated type of bond is the convertible bond (convertibles), one that comes with an option for it to be converted into a predetermined amount of the company's equity at certain times during its life, usually at the discretion of the bondholder. Convertibles are sometimes called "CVs".

Issuing convertible bonds is one way for a company to minimize negative investor interpretation of its corporate actions. For example, if an already public company chooses to issue stock, the market usually interprets this as a sign that the company's share price is somewhat overvalued. To avoid this negative impression, the company may choose to issue convertible bonds, which bondholders will likely convert to equity anyway should the company continue to do well.

From the investor's perspective, a convertible bond has a value-added component built into it; it is essentially a bond with a stock option hidden inside. Thus, it tends to offer a lower rate of return in exchange for the value of the option to trade the bond into stock. Obviously if the bondholder exercises his option and converts the bond into stock, he becomes a stockholder of the co. and he doesn't get the bond principal returned to him. Of course he can choose not to exercise his option in which case he will have the principal returned to him.