Convertible Bond

What Is a Convertible Bond?

A convertible bond is a type of corporate bond that gives the holder the right, but not the obligation, to convert the bond into a predetermined number of shares of the issuing company's common stock. Until conversion, it behaves like a regular bond: the issuer pays periodic coupon payments and returns the face value at maturity. The conversion feature is what sets it apart, because it links the bond's value partly to the performance of the company's stock.

How It Works

Each convertible bond specifies a conversion ratio, which is the number of shares received per bond, or equivalently a conversion price, the effective price per share paid through the bond. If the company's stock rises well above the conversion price, converting becomes attractive, since the shares are worth more than the bond's face value. If the stock stays low, the holder can keep the bond and collect interest, and the bond's price tends to be supported by its debt value.

Convertibles usually pay a lower coupon than ordinary bonds from the same issuer. The conversion option is the trade-off: investors accept less interest in exchange for the potential upside of the stock. Issuers often use convertibles to borrow at lower cost, sometimes at a premium to the current share price.

Example

Suppose a company issues a bond with a $1,000 face value and a conversion price of $50, meaning each bond converts into 20 shares. If the stock later trades at $70, the conversion shares are worth $1,400, which is more than the bond's face value. If the stock stays at $30, the shares would be worth only $600, so the holder would likely keep the bond and receive interest and principal instead.

Why It Matters to Investors

Convertible bonds can offer a middle ground between the income of debt and the growth potential of equity. They may fall less than stock during market declines, but they can still lose value if the issuer's credit weakens. Their prices are influenced by interest rates, the underlying stock price, the company's credit quality, and the time remaining before conversion. Investors should read the terms carefully, including any call provisions that let the issuer force conversion or redeem the bond early.