Convertible Bonds

Convertible Bonds

What Does Convertible Bond Mean?

A bond that can be converted into a predetermined amount of the company’s equity at certain times during its life, usually at the discretion of the bondholder.

Investopedia explains Convertible Bond

ssuing convertible bonds is one way for a company to minimize negative investor interpretation of its corporate actions. For example, if an already public company chooses to issue stock, the market usually interprets this as a sign that the company’s share price is somewhat overvalued. To avoid this negative impression, the company may choose to issue convertible bonds, which bondholders will likely convert to equity anyway should the company continue to do well.

From the investor’s perspective, a convertible bond has a value-added component built into it; it is essentially a bond with a stock option hidden inside. Thus, it tends to offer a lower rate of return in exchange for the value of the option to trade the bond into stock.

New players to the investing game often ask what convertible bonds are. and whether they are bonds or stocks. Essentially, they are corporate bonds that can be converted by the holder into the common stock of the issuing company. In this article, we’ll cover the basics of these chameleon-like securities as well as their upsides and downsides.

What Is a Convertible Bond?

As the name implies, convertible bonds, or converts, give the holder the option to exchange the bond for a predetermined number of shares in the issuing company. When first issued, they act just like regular corporate bonds, albeit with a slightly lower interest rate. Because convertibles can be changed into stock and thus benefit from a rise in the price of the underlying stock, companies offer lower yields on convertibles. If the stock performs poorly there is no conversion and an investor is stuck with the bonds sub-par return (below what a non-convertible corporate bond would get). As always, there is a tradeoff between risk and return. (For more insight, read Get Acquainted With The Bond Price-Yield Duo .)

Conversion Ratio

The conversion ratio (also called the conversion premium ) determines how many shares can be converted from each bond. This can be expressed as a ratio or as the conversion price. and is specified in the indenture along with other provisions.