Convertible Bond

A convertible bond is a type of bond that gives the holder the option to convert the bond into a specified number of shares of common stock of the issuing company at a predetermined conversion price. Convertible bonds offer the potential for capital appreciation if the stock price of the issuing company rises, while also providing the relative safety of fixed income if the stock price falls.

Convertible bonds are issued by companies that are looking to raise capital while minimizing the cost of borrowing. The bonds typically have a lower coupon rate than non-convertible bonds, as investors are willing to accept a lower yield in exchange for the option to convert the bonds into common stock.

The conversion price of a convertible bond is typically set at a premium to the current market price of the common stock, to provide an incentive for investors to purchase the bonds. The premium also provides a cushion against any decline in the stock price, as the conversion value of the bond will be higher than the market value of the bond.

If the stock price of the issuing company rises above the conversion price, the holder of the convertible bond may choose to convert the bond into a common stock, as the value of the common stock will be greater than the value of the bond. If the stock price falls below the conversion price, the holder of the convertible bond may choose to hold onto the bond and continue to receive interest payments until maturity.

To illustrate some key concepts of convertible bonds, consider the following example:

Example: A company issues a convertible bond with a principal amount of $1,000 and a coupon rate of 4%. The bond has a conversion price of $50 per share, which is a 20% premium to the current market price of the common stock.

If the market price of the common stock is currently $40 per share, the conversion price of $50 per share represents a potential capital gain of 25% if the stock price rises above the conversion price. If the stock price falls below the conversion price, the bondholder can continue to receive interest payments until maturity.

If the market price of the common stock rises to $60 per share, the bondholder may choose to convert the bond into a common stock, as the value of the common stock will be greater than the value of the bond. The bondholder would receive 20 shares of common stock for every $1,000 of principal upon conversion.

In conclusion, convertible bonds are a type of bond that offers the option to convert the bond into a specified number of shares of common stock at a predetermined conversion price. Convertible bonds offer the potential for capital appreciation if the stock price of the issuing company rises, while also providing the relative safety of fixed income if the stock price falls. Convertible bonds are typically issued by companies that are looking to raise capital while minimizing the cost of borrowing and are attractive to investors who are looking for a balance of income and potential capital gains.

See Also

• Conversion Ratio - Specifies how many shares of common stock can be acquired through the conversion of one convertible bond. The conversion ratio is fundamental to understanding the value proposition of a convertible bond.
• Conversion Price - The pre-determined price per share at which a convertible bond can be converted into shares of common stock. This is directly used to calculate the conversion ratio and is intrinsically tied to the convertible bond.
• Preferred Stock - Another type of convertible security that can be converted into common shares. While not a bond, the conversion features are similar.
• Capital Structure - Refers to how a firm finances its operations and growth with different kinds of securities, such as debt or equity. Convertible bonds are hybrid instruments that can affect a company's capital structure.