What it is:
How it works (Example):
For example, consider a Company XYZ bond with a $1,000 par value that is convertible into Company XYZ common stock. It has a coupon of 6%, payable annually. The bond’s prospectus specifies a conversion ratio, which is the number of shares that the investor will receive if he chooses to convert. In this example, Company XYZ’s convertible bond has a conversion ratio of 20. The investor is effectively purchasing 20 shares of Stock XYZ for $50 per share ($1000 / 20 = $50).
The bondholder keeps the bond for two years and collects a $60 interest payment each year. At the end of year two, he elects to convert his bond into 20 shares of stock. By this time, the stock price has risen to $75 per share. The bondholder converts his bond to 20 shares at $75 per share, and now his investment is worth $1,500.
The conversion ratio is not the only aspect of a convertible bond to analyze. Like other bonds, convertible bonds usually offer a coupon, and their prices are based on prevailing market rates and the credit quality of the issuer.
Why it Matters:
A firm issuing debt may add a convertibility feature to make the bonds more attractive to investors. The firm may be able to get a lower interest rate or better terms by adding a convertibility feature.
From the investor's perspective, a convertibility feature allows for collection of a steady stream of interest income plus an opportunity to take advantage of future stock price appreciation. Investors should be aware of the issuer's credit quality before investing and that there is reinvestment risk if the bond is callable. Investors should thoroughly review a bond’s prospectus before investing.