Convertible Bond
A convertible bond is a corporate bond that can be converted into a predetermined number of the company's common stock shares, offering both fixed income and equity upside potential.
Exam Tip
Convertible = lower yield than regular bonds. Conversion Ratio = Par ÷ Conversion Price. Convert when stock > conversion price.
What is a Convertible Bond?
A convertible bond is a hybrid security that combines features of bonds and stocks. It pays regular interest like a bond but can be converted into the issuer's common stock at a predetermined conversion ratio.
Key Features
| Feature | Description |
|---|---|
| Coupon Payments | Regular interest payments (usually lower than regular bonds) |
| Conversion Right | Option to convert to stock at holder's choice |
| Conversion Ratio | Number of shares received per bond |
| Conversion Price | Effective price paid per share upon conversion |
Conversion Terms
Conversion Ratio = Par Value ÷ Conversion Price
Example:
- Bond par value: $1,000
- Conversion price: $50 per share
- Conversion ratio: $1,000 ÷ $50 = 20 shares
When to Convert
| Stock Price vs. Conversion Price | Action |
|---|---|
| Stock < Conversion Price | Hold as bond (collect interest) |
| Stock = Conversion Price | At the money (either option) |
| Stock > Conversion Price | Consider converting for profit |
Example Calculation
| Factor | Value |
|---|---|
| Bond Par Value | $1,000 |
| Conversion Ratio | 20 shares |
| Conversion Price | $50/share |
| Current Stock Price | $60/share |
| Conversion Value | 20 × $60 = $1,200 |
| Profit if Converted | $200 |
Pros and Cons
| Pros | Cons |
|---|---|
| Lower yield than regular bonds | Called if stock rises significantly |
| Downside protection (bond floor) | Dilution when converted |
| Equity upside participation | More complex to value |
| Lower coupon = less interest expense for issuer | Interest rate risk still applies |
Convertible Bond vs. Regular Bond
| Feature | Convertible | Regular Bond |
|---|---|---|
| Coupon Rate | Lower | Higher |
| Upside Potential | Yes (equity conversion) | No |
| Downside Protection | Yes (bond floor) | Yes (principal) |
| Complexity | Higher | Lower |
Forced Conversion
Issuers can force conversion by calling the bond when stock price rises significantly above conversion price. Holders must either:
- Convert to stock (usually better)
- Accept the call price (usually worse)
Investment Considerations
| Investor Type | Suitable? |
|---|---|
| Income Seekers | Moderate (lower coupon) |
| Growth Seekers | Good (equity upside) |
| Conservative | Good (downside protection) |
Exam Alert
Convertible bonds have LOWER yields than non-convertible bonds because of the conversion privilege. Know conversion ratio and conversion price calculations. Forced conversion happens when issuer calls the bond.