A convertible bond is a type of bond that gives the bondholder the option to convert their bond into a predetermined number of shares of the issuing company's stock. This type of bond combines features of both debt and equity, providing benefits to both issuers and investors.
Definition: The primary feature of a convertible bond is that it can be converted into a specified number of shares of the issuing company’s stock.
Conversion Ratio: The conversion ratio determines how many shares of stock the bondholder will receive upon conversion. It is typically set at the time of issuance.
Definition: The conversion price is the price at which the bond can be converted into shares. It is derived from the face value of the bond divided by the conversion ratio.
Example: If a bond with a face value of $1,000 has a conversion ratio of 20, the conversion price would be $50 per share.
Definition: Convertible bonds pay interest, known as the coupon rate, which is usually lower than the interest rate on similar non-convertible bonds because of the conversion option.
Definition: Like other bonds, convertible bonds have a maturity date at which the principal amount is repaid if the bond has not been converted to equity.
Issuers can offer a lower interest rate compared to regular bonds because the conversion feature is attractive to investors.
Conversion into equity occurs only when bondholders choose to convert, which can defer dilution of existing shareholders' equity.
Investors benefit from the potential upside if the company’s stock performs well and the bond is converted into shares.
Until conversion, investors receive regular interest payments, providing some level of income and downside protection.
If the company’s stock does not perform well, the conversion option may not be attractive, and the bond will behave like a regular bond with lower yields.
Convertible bonds are subject to the credit risk of the issuer, similar to other corporate bonds.
Consider a company that issues a convertible bond with the following terms:
If the company’s stock price rises above $40 ($1,000 face value / 25 conversion ratio), the bondholder might choose to convert the bond into shares. For instance, if the stock price rises to $50, converting the bond would yield shares worth $1,250 (25 shares * $50 per share).
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