What It Is:

A convertible bond is a security that allows the holder to exchange the bond for another security (typically common stock).

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. If the conversion price of the common shares is $25, then the bondholder can convert each of his or her bonds into 40 Company XYZ shares ($1,000 / $25 = 40).

What makes this feature attractive to investors is that it allows bond holders to participate in the appreciation of the underlying security. If the market price of XYZ common stock is currently $35 then bondholders may be motivated to convert, because they could convert their bonds and receive 40 shares at a price of $25 and immediately sell them on the market for $35, netting a $10 profit per share.

The conversion price 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:

Convertible bond s allow firms that may not be able to issue regular bonds at a reasonable price. The convertibility feature makes the bonds more attractive to investors.

From the investor's perspective, it allows them to receive fixed income but not miss out on potential capital gains. But investors should be aware of the issuer's credit quality before investing and that there is reinvestment risk if the bond is callable.