What is a convertible bond?

By Chad Langager AAA
A:

A convertible bond is a bond issued by a corporation that, unlike a regular bond, gives the bondholder the option to trade in the bond for shares in the company that issued it. This gives the bondholder both a fixed-income investment with coupon payments as well as the potential to benefit from an increase in the company's share price. The additional value of the conversion option, however, will mean that the coupon payment on the bond will be lower than that of an equivalent bond with no conversion option.

A convertible bond issue, like that of other bonds, will state the maturity and the coupon on the bond. A convertible bond also has information about the conversion option, or how many shares will be received for the bond if it is converted.

For example, take a convertible bond that sells for $1,000. It has an annual coupon of 7% and can be converted into 100 shares at any time. Each year, the bondholder will receive $70 ($1,000 x 7%) as long as the bond has not been converted into shares. If the bondholder were to convert the bond into shares, he or she would no longer receive the coupon payment (interest), and the value of the investment would move with the price of the stock.

Based on the number of shares that will be received upon conversion and the price paid for the bond, the effective share purchase price can be calculated. In the example above, the effective price that the bondholder pays for the shares would be the price paid divided by the amount of shares received, or $10 ($1,000/100). The investor will only convert the bond into shares if the current share price is higher than the effective share purchase price.



An investor would, however, convert a bond into shares if the share value rose to $20. He or she would receive 100 shares and the market value of the shares would be $2,000. On the other hand, if the share price was $5, an investor would keep the bond and receive the payments on the bond because if converted, the market value of the shares would be only $500.

(For more about convertible bonds, read Convertible Bonds: An Introduction, Bond Basics Tutorial and Advanced Bond Concepts.)

RELATED FAQS

  1. Why should I keep records on my tax-exempt bond transactions?

    Keep your purchase records on all investments, including tax-exempt bonds. Though the interest is tax-free, you may owe taxes ...
  2. How long will it take for a bond to reach its face value?

    Learn when different savings bonds reach face value, and determine the best time to cash them in to get the highest return ...
  3. How long can I hold my HH/H Bonds and still earn interest?

    Take advantage of your bond investment and learn how long you can hold on to your Series H/HH Bonds and still earn interest ...
  4. How do I sign up for a TreasuryDirect account?

    Invest in Treasury securities by dealing directly with the U.S. Department of the Treasury online, conveniently managing ...
RELATED TERMS
  1. Class 3-6 Bonds

    Several classes of noninvestment grade bonds held by an insurance ...
  2. Impact investing

  3. Promotional CD rate (Bonus CD rate)

    A limited-time offer of a higher rate of return on a certificate ...
  4. Direct Bidder

    An entity that purchases Treasury securities at auction for a ...
  5. Indirect Bidder

    An entity that purchases Treasury securities at auction through ...
  6. Bid Wanted

    An announcement by an investor who holds a security that he or ...
Related Articles
  1. How Does Janus's Fund Lineup Look Now?
    Investing Basics

    How Does Janus's Fund Lineup Look Now?

  2. Thank You, Pimco: BlackRock Drops Bond-Fund ...
    Investing Basics

    Thank You, Pimco: BlackRock Drops Bond-Fund ...

  3. Preferred Stocks versus Bonds: How to ...
    Trading Strategies

    Preferred Stocks versus Bonds: How to ...

  4. Why BOND Still Might Be In A Class Of ...
    Investing

    Why BOND Still Might Be In A Class Of ...

  5. Keeping More Of Your ETF Capital Gains ...
    Investing

    Keeping More Of Your ETF Capital Gains ...

Trading Center