Why should investors consider convertibles?

Equity like returns with lower risk
Given their link to the price of the underlying equity convertibles provide investors with exposure to rising share prices but, because of their fixed interest characteristics, they also protect against falls in the equity market. Convertibles can improve investors' risk/reward profile.
Higher yielding exposure than holding equity
Convertibles generally pay a higher rate of interest than the equity yield available on the underlying shares. Thus, holders of the convertible will share in any share price appreciation and also receive a higher level of income. If the shares do not perform well at least the holder of the convertible will be compensated by the yield pick-up.
Gives fixed interest investors exposure to rising equity prices
Fixed interest investors that are restricted from owning equities can gain exposure to rising share prices via convertible stocks. Although they are classified as fixed interest instruments they provide a link to the equity price of the underlying company.
Potential special situations in event of corporate failure
Convertibles rank above a company’s ordinary share capital and, should the issuer get into financial problems, the superior ranking can be valuable. Shareholders have no recourse when a company has to forego its equity dividend but the non-payment of an interest payment on a convertible bond or loan stock would cause default. Although preference share dividends can be postponed the payments are usually cumulative and any arrears must be paid in full before an equity dividend can be paid. This can lead to situations where the issuer of a convertible proposes conversion or redemption on advantageous terms as part of a balance sheet reconstruction.

Why should issuers consider convertibles?

Lower coupon cost than debt issue
The presence of the conversion option means that investors are prepared to accept a lower rate of interest on a convertible than they would on a straight fixed interest stock of similar maturity.
Raise more money than a rights issue
When a company raises finance via the issue of new shares in a rights issue those shares are issued at a discount to the market price. Conversely, when a convertible is issued the conversion price is set at a premium to the prevailing share price.
Increases investor base
Many companies like to have as broad an investor base as possible, ranging from holders of shares to straight bonds. Convertible investors add to the variety of holders of the company’s securities.
Use equity volatility to extract good terms
A number of investors trade convertibles on an arbitrage basis, generating cash flows from the different rate of price movements on the convertible and the underlying equity. Such investors can make more money if the rate of equity volatility is high. Most new convertibles are now aimed at hedge fund investors and, if the underlying equity has high enough volatility, these investors will accept a lower rate of interest and higher premium than traditional investors.
Monetise stakes in other companies via exchangeable bonds
Once a company has built up a stake in another company it can issue an exchangeable bond. The issuing company pays the coupons and will redeem the bonds if necessary, but conversion is into the shares of the other company. In this way the issuing company raises more money, because of the conversion premium, than if the stake were simply placed in the market. The issuing company need not even give up its stake in the underlying company on conversion, as it will retain the right to pay converting holders the cash value of the shares rather than the actual shares.