We are gonna start by understanding what convertibles are at.

Its very simplest. A convertible is a loan, typically a bond with an embedded derivative.

And that embedded derivative allows you to convert the bond into equity.

And some cases the equity will be given in informal shares.

In other cases, you may actually receive cash to the value of the share value.

And you can either hold the instrument to maturity, and at maturity you can decide to get the bond redeemed.

Or if the embedded derivative is in the money, then you can take the option to receive shares, or in some cases cash equal to the value of shares.

So that's in essence what a convertible is.

It's just a loan with embedded derivative to allow you to convert the loan into equity.

And typically that conversion is a choice.

In some cases may be mandatory, but in most cases it's a choice.

Now, why do people issue convertibles? Well, typically the convertibles have a, um, a lower interest cost.

And this is a low, typically cash interest cost because the embedded derivative holds value.

So investors are willing to accept a lower cash interest rate on the instrument because of the embedded option, and that makes it attractive to companies who want to issue debt with low cash interest costs.

The embedded derivative can be accounted for separately.

Now it depends on the accounting a little bit, and the US gap accounting is quite complex.

And in IFRS you will generally separate out the derivative.

And in both cases though, under IRS and US gap, you can elect to, um, hold the instrument at fair value, which means the whole thing gets just revalued on a period by period basis.

But in a lot of cases, the embedded options accounted for separately, depending on the exact terms of conversion.

The accounting may treat the convertible as a liability or equity, and in some cases it will split the accounting.

So part of the instrument is treated as a liability and part of the instrument is treated as equity.

So the, the accounting can get quite complex.

And the rules here are different between US GAAP and IFRS, which makes it more annoying and difficult to understand.

But broadly speaking, there are a number of different rules and you need to understand the rules for the US gap treatment and IRS. But in both cases, you can have elements of the convertible treated as either debt or equity.

If the accounting treats the item, the derivative as a financial liability or at fair value, then you'll need to record changes in the fair value Through the income statement on a yearly basis.

And the reason that this is important is it can start to introduce volatility into the company's income statement.

So there some downsides to issuing convertibles because of this volatility.

Now, most holders of these instruments will typically hold the bond and not exercise it until you are very close to the expiry date. And the reason for that is you want to capture as much of the time value as possible.

Now, if they do want to sell it before then they'll typically sell it to another investor so they capture the time value up to that point and that other investor will hold until expiry.

In some cases, these convertibles can be called by the issuer.

In other words, the issuer can say, well, we are actually going to redeem the bond early.

And there's not one standard design of convertible. There are lots of different idiosyncrasies of these instruments.

So it's worth really understanding the type of instrument and the type of bells and whistles it has before you even start looking at the accounting.