A convertible bond is a mix between a corporate bond and a stock option. It will pay interest like a bond, but you have the option to exchange it for a certain number of the corporation’s stock shares. If you’re drawn to safer investments, but would still like to earn a little capital, convertible bonds may be appealing.
A Safer Investment
Corporations issue convertible bonds, available to investors, which pay interest at regular intervals. You as the investor can convert some of your bond holdings into stock shares. But your stocks are not as vulnerable to market swings as typical stock shares. If a stock loses value, your investment will be safer. Convertible bonds are like a hybrid between a fixed-income investment and a traditional stock investment.
Convertible bonds, unlike more typical stock shares, have a floor value. If the stock value of your convertible bond is dropping, you won’t be able to convert the bond to stock. But, your profit will still be the bond’s yield. You will receive your principal on a specified maturity date.
If the corporation you’re investing in goes bankrupt, however, that is the one time that your convertible bond can cause a loss.
Basics of Convertible Bonds
Convertible bonds have fixed coupon rates and par values. The coupon rate is the yield paid by a fixed income security. The par value is the face value of a bond.
The conversion ratio is the number of shares that you as an investor receive if you exercise a conversion. You can choose to convert a convertible bond into a stock share, or you may have mandatory convertible bonds which convert to common stock shares upon maturity of the bond.
The conversion ratio is the number of shares of common stock that a bond can be converted to. A 10-to-one ratio, for example, means that one bond can be converted into 10 shares of stock.
So if you have a five-year convertible bond with a $1,000 face value, and a coupon, or yield of 5 percent, the conversion ratio, meaning the number of shares you receive when you exercise your conversion option, is 25.
Understanding Conversion Price
The conversion price is the number of converted shares which equals the par value or face value of the bond.
So for our five-year convertible bond with the $1,000 face value and the 5-percent yield or par, that means the conversion price is $40 per share, or $1,000 divided by 25. If you hold onto the convertible bond for three years and receive $50 in income each year and the stock is trading at $60 per share, your yield will increase also. If you convert the bond and receive 25 shares of stock at $60 per share, your convertible bonds will have a total value of $1,500.
If the stock value falls to $25 instead of rising to $60, you would hold onto the bond until it matures in five years. You would receive $250 in income over that five-year period. And you would receive your $1,000 back upon maturity of the bond.
When convertible bonds are issued, the price of the stock is usually less than the conversion price. The amount that the conversion price exceeds the stock price is called the conversion premium.
More Like Stocks
The performance of convertible bonds is usually correlated to stocks rather than to high-quality bonds.
If you have a $1,000 bond, convertible to 50 shares of stock, the conversion price is $1,000 divided by 50, or $20 per share. If that share price is below $20, your investment acts more like a bond. If the stock price is above $20, the stock will have more value and your yield or par will rise.