Convertible Bonds Explained

Identification

Convertible bonds are issued by corporations as another form of debt security. Convertibles have the usual features of bonds such as face value, coupon or interest payment and a maturity date. The added feature of convertible bonds is the right of the bond holder to convert the bond into a set number of share of common stock of the issuing company.

Corporations issue convertible bonds to save on their interest expense. Convertible bonds can be sold at an interest rate significantly lower than rate on the corporation's regular bonds. Investors are willing to accept the lower rate in exchange for the ability to convert the bonds to common stock. Convertible bonds are issued with a stock conversion price significantly higher that the current share price. If the stock performs well enough to reach the conversion price, both investors and corporate management will be happy.

Convertible bonds have a conversion ratio or conversion price. The conversion ratio is the number of shares that each $1,000 bond can be converted into. The conversion price is the cost of the shares if a $1,000 bond is converted. The ratio and price are the inverse of each other. If a bond has a conversion ratio of 40, dividing 1,000 by 40 shares give a conversion price of $25. If the conversion price is $25, each bond can be converted into 40 shares.

The convertible bondholder has the right to convert the bond to stock or retain the bond. If the stock exceeds the conversion price the bond value will move up in value parallel to the stock price. The issuing corporation can force a conversion by calling the bond. Bondholders would then convert to the common stock rather than receiving the face amount of the bond which is less than the value of the converted stock.

Convertible bonds are a conservative way to possibly participate in the value gain of a company stock. If the stock price is below the conversion value, the investor will receive regular interest payments from the bond. As the stock moves higher, the value of the bond will move with the stock price. If the stock falls in value, the bonds interest payment and maturity date will keep the bond from falling much below the face value of the bond.