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.)