Convertible Bonds

Convertible bonds are bonds that give the bondholder the right to exchange the bond for a predetermined number of shares of the issuing companies stock. A convertible bond is very similar to a corporate bond. The key difference is that the convertible bond can be converted by the bondholder into common stock of the company. Typically a convertible bond will have a lower interest rate than a corporate bond, because of the ability of the bond holder to convert the bond into shares of stock. Bond investors who buy convertible bonds are hoping for a sharp rise in the price of the companies stock. A rise in the stock price will benefit the holder of the bond since he has the right to convert his bond into shares of stock.

Convertible bonds have what's called a conversion ratio. A conversion ratio defines how many shares of stock can be converted from each bond.

A convertible bond will state the maturity and the coupon on the bond. It will also have information about the conversion option, or how many shares will be exchanged for the bond if it is converted.

For example, take a convertible bond that sells for $1,000. It has an annual coupon rate of 8% and can be converted into 100 shares of company stock at any time. Each year, the bondholder will receive a payment $80 ($1,000 x 8%) as long as the bond is not converted. If the bondholder converts the bond into shares of the companies stock, they would no longer receive the interest payment, and the value of the investment would move with the price of the stock.

Convertible bonds also have a feature built in that is called "forced conversion". This means that the issuing company has the right to forcibly convert the bonds if the underlying stock price has a sharp increase before the call date.

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