what is a convertible bond 
a convertible bond is a fixed income corporate debt security that yields interest payments but can be converted into a predetermined number of common stock or equity shares the conversion from the bond to stock can be done at certain times during the bond s life and is usually at the discretion of the bondholder as a hybrid security the price of a convertible bond is especially sensitive to changes in interest rates the price of the underlying stock and the issuer s credit rating investopedia ryan oakleyunderstanding convertible bondsconvertible bonds are a flexible financing option for companies a convertible bond offers investors a type of hybrid security which has features of a bond such as interest payments while also providing the opportunity of owning the stock this bond s conversion ratio determines how many shares of stock you can get from converting one bond for example a 5 1 ratio means that one bond would convert to five shares of common stock the conversion price is the price per share at which a convertible security such as corporate bonds or preferred shares can be converted into common stock the conversion price is set when the conversion ratio is decided for a convertible security the conversion price and ratio can be found in the bond indenture for convertible bonds or the security prospectus for convertible preferred shares we ll discuss how the conversion ratio is calculated more later in this article bond issuers might also force or exercise their right to call the bond if interest rates are favorable with a forced conversion the investor does not have a say in holding or converting their bond one version of convertible bonds is known as death spiral debt with this version the bond is converted into a fixed dollar value paid in shares investors holding this convertible will jump in to convert their holdings if the stock price declines substantially this action can further dilute shares and drive the price even further downward you do not have to convert a convertible bond you can simply let it ride to maturity and let it act like a regular bond convertible bonds vs regular bondsconvertible bonds and regular bonds are very similar in many ways but they do differ in addition to the conversion feature there s a few other points worth mentioning on the difference between convertible bonds and regular bonds first convertible bondholders have the option to participate in the company s equity while a regular bond is simply a debt instrument a convertible bond gives investors the opportunity to benefit from capital appreciation if the company s stock price increases second convertible bonds typically offer lower interest rates compared to regular bonds because of the added potential for equity participation through conversion regular bonds on the other hand offer higher interest rates to compensate investors for the absence of equity upside convertible bonds are also often traded on secondary markets meaning investors can choose to buy or sell them before maturity with regular bonds you can do this as well however the liquidity of each of these types of bonds may be dramatically different depending on the issuer s credit rating and prevailing market conditions for example a single company could issue both types of bonds depending on that company investors may have a higher appetite and therefore drive higher liquidity for one type over the other last convertible bonds could theoretically be used as a rebalancing tool for portfolio management if an investor realizes they ve become overweight in debt instruments they could convert their bond instead of having to sell a position this flexibility just isn t present with regular bonds features of convertible bondslet s run though the general features of convertible bonds much of this information is sprinkled throughout this article here s a comprehensive list of features you can usually expect when dealing with convertible bonds convertible bond arbitrage is a trading strategy that aims to capitalize on mispricing between a convertible bond and its underlying stock varieties of convertible bondsa vanilla convertible bond provides the investor with the choice to hold the bond until maturity or convert it to stock if the stock price has decreased since the bond s issue date the investor can hold the bond until maturity and get paid the face value if the stock price increases significantly the investor can convert the bond to stock and either hold or sell the stock at their discretion ideally an investor wants to convert the bond to stock when the gain from the stock sale exceeds the face value of the bond plus the total amount of remaining interest payments mandatory convertible bonds are required to be converted by the investor at a particular conversion ratio and price level on the other hand a reversible convertible bond gives the company the right to convert the bond to equity shares or keep the bond as a fixed income investment until maturity if the bond is converted it is done so at a preset price and conversion ratio calculating the conversion price of convertible bondstypically the conversion price is set at a premium to the current market price of the stock at the time of issuance this premium is designed to provide an incentive for investors to convert their bonds into equity as it ensures that they can acquire shares at a lower price than what they would pay if they were to purchase them on the open market the calculation of the conversion price is relatively straightforward it is calculated by dividing the bond s face value by the conversion ratio the conversion ratio specifies the number of shares that a bondholder will receive upon conversion for example if a convertible bond with a face value of 1 000 has a conversion ratio of 20 the conversion price would be 50 per share 1 000 divided by 20 this means that for each bond they hold the bondholder has the right to convert it into 20 shares of the company s stock at a price of 50 per share in most cases the conversion ratio of a convertible bond remains fixed throughout the life of the bond when a convertible bond is issued the conversion ratio is established and specified in the bond s terms this ratio usually doesn t change so in the example above the investor could always exchange the bond for 20 shares regardless of share price however when the instrument is created the conversion rate may be set to be unfavorable to convert if the conversion price were set at or below the market price of the stock bondholders could potentially convert their bonds and immediately sell the shares at a profit effectively deeming the debt instrument process worthless therefore in the example above 20 shares of stock may be worth 950 in the open market an investor may simply prefer to hold equity instead of debt so they accept the conversion price that is less favorable than the market advantages and disadvantages of convertible bondsissuing convertible bonds can help companies minimize negative investor sentiment that would surround equity issuance each time a company issues additional shares or equity it adds to the number of shares outstanding and dilutes existing investor ownership the company might issue convertible bonds to avoid negative sentiment bondholders can then convert into equity shares should the company perform well issuing convertible bonds can also help provide investors with some security in the event of default a convertible bond protects investors principal on the downside but allows them to participate in the upside should the underlying company succeed a startup company for example might have a project that requires a significant amount of capital resulting in a loss in the near term revenues however the project should lead the company to profitability in the future convertible bond investors can get back some of their principal upon failure of the company while they can also benefit from capital appreciation by converting the bonds into equity if the company is successful investors can enjoy the value added component built into convertible bonds meaning they re essentially a bond with a stock option particularly a call option a call option is an agreement that gives the option buyer the right not the obligation to buy a stock bond or other instruments at a specified price within a specific period however convertible bonds tend to offer a lower coupon rate or rate of return in exchange for the value of the option to convert the bond into common stock the lower value is known as the bond floor companies benefit since they can issue debt at lower interest rates than with traditional bond offerings however not all companies offer convertible bonds also most convertible bonds are considered to be riskier more volatile than typical fixed income instruments investors receive fixed rate interest payments with the option to convert to stock and benefit from stock price appreciation investors get some default risk security since bondholders are paid before common stockholders companies benefit by raising capital without immediately diluting their shares companies may pay lower interest rates on their debt compared to using traditional bonds due to the option to convert the bond into common stock they offer a lower coupon rate issuing companies with little or no earnings like startups create an additional risk for convertible bond investors share dilution happens if the bonds convert to stock shares which may depress the share s price and eps dynamics convertible bonds and taxesthere s a few things to keep in mind regarding taxes and convertible bonds note that if convertible bonds are held in a tax advantaged account the notes to follow may be different first convertible bonds typically pay periodic interest payments to bondholders this interest income is generally taxable as ordinary income in the year it is received 1if a convertible bond is converted into shares of the issuing company s stock and the investor subsequently sells the shares any capital gains or losses realized from the sale will likely be subject to capital gains tax when a convertible bond is converted into shares the conversion itself is not typically taxable however any subsequent capital gains or losses realized from the sale of the shares would be 2some convertible bonds may be issued at a discount to their face value resulting in an original issue discount oid oid is generally taxable as ordinary income over the life of the bond regardless of whether you hold the bond to maturity or sells it before maturity when a convertible bond is converted into shares 3last if the convertible bond is converted into shares of stock and the issuing company pays dividends on the shares any dividends received may be eligible for preferential tax treatment as qualified dividends qualified dividends are subject to lower tax rates than ordinary income tax rates for eligible investors 1example of a convertible bondas an example let s say exxon mobil corp xom issued a convertible bond with a 1 000 face value that pays 4 interest the bond has a maturity of 10 years and a convertible ratio of 100 shares for every convertible bond if the bond is held until maturity the investor will be paid 1 000 in principal plus 40 in interest for that year however the company s shares suddenly spike and are trading at 11 per share as a result the 100 shares of stock are worth 1 100 100 shares x 11 share price which exceeds the value of the bond the investor can convert the bond into stock and receive 100 shares which could be sold in the market for 1 100 in total 