Convertible debt refers to loan agreements that include a provision allowing the creditor to convert the debt into an equity share in a piece of property or a publicly traded company. For creditors the pros of convertible debt include minimal principal risk and the opportunity for growth while the downsides include low-income payments. A convertible debt is less expensive for a debtor to manage in the short-term but in the long-term, it could prove to be quite costly.
In many cases, convertible debt agreements take the form of corporate bond offerings. The bondholders have the opportunity to change these debts into company shares at a specific date in the future. If the company goes bankrupt prior to the conversion then the claims of bondholders on the firm's assets are settled before shareholders have a chance to claim any assets. Therefore, convertible debts expose investors to lower levels of principal risk than stocks. Additionally, if the firm continues to grow then the bondholders experience the upside of the firm's growth by converting the debt into equity.
In the investment arena, reduced levels of risk are normally accompanied by reduced earning potential. Therefore, the yields paid on convertible debts are much lower than on standard bond products. Furthermore, while convertible bonds are relatively safe investments, in many instances both bondholders and shareholders lose some or all of their investment when a firm becomes insolvent. Some banks write convertible mortgage products that provide the bank with a share of ownership in the borrower's property. When home prices are rising such loans are attractive to lenders; if home prices fall, then the debt balance may exceed the property value.
Companies can keep borrowing costs low by issuing convertible rather than standard bonds since the interest payments on these debts are much lower than on conventional debts. In the long run, convertible debt agreements can prove costly to debt issuers if the company increases in value and the creditor decides to activate the conversion option. Conversion agreements enable the creditor to exchange the bonds for a specific number of shares but the more those shares are worth, the more money the debt issuer stands to lose as a result of the conversion.
Borrowers who take out convertible mortgages often pay lower rates of interest than people who take out conventional loans. In the short-term, this means that these borrowers can finance expensive properties while keeping their monthly payments low. In the long-term, if the property prices rise then much of the property owner’s equity is lost to the lender as a result of the debt conversion.