Convertible bonds

A convertible bond gives a right to the bondholder to convert the bond into a fixed number of shares of the common stock, of the bond issuing company. The coupon rate of convertible bonds is generally lower than the regular bonds. The company issuing the convertible bonds are at an advantage as the debt issued in terms of the bonds can be removed from the books of accounts by converting them into common stock. This conversion can lead to stock dilution which places the common shareholders at a disadvantage. Convertible bonds are generally issued by the companies which have a low credit rating to make the bonds more attractive to the investors.

Example:

Suppose a company XYZ issues convertible bonds with a $1000 par value, maturity of one year, and a coupon rate of 6% which is paid annually. An investor buys the XYZ bond which is trading at par. The bond specifies a conversion ratio of 20:1 (one bond can be exchanged for 20 shares of stock). This gives the investor a right to purchase 20 shares of company XYZ for $50 per share ($1000/20 = $50).

Suppose the investor keeps the bond for one year and collects $60 interest. At the end of the year, he chooses to convert the bond into 20 shares of stock. By this time, if the stock price rises to $65 per share, the bondholder can convert the bond to 20 shares at the current market price of $65, and then his initial investment of $1000, will now be worth of $1200 plus the annual cash flow which he received as coupon payment for holding the bond for one year. If the stock price drops to $40 the bond holder would still be paid the face value of the $1000 at maturity.