Features

• A convertible bond is a debt security from a corporation that can be converted at the bond owner's discretion into shares of the company's common stock. The features of the bond include the coupon rate or annual interest paid and the conversion factor, or how many shares of stock a $1,000 bond can be converted into. Corporations issue convertible bonds because they will pay a lower rate of interest in return for the investors receiving the right to convert. The conversion is calculated from a conversion ratio or conversion price. If a $1,000 bond has a conversion ratio of 20, it can be converted into 20 shares of stock. The $1,000 divided by 20 provides a conversion price of $50.
  
  

Function

• Convertible bonds are usually issued with a conversion price well above the market price. The purpose of issuing the bonds is to borrow money so the company can grow and, hopefully, so will the stock price. While waiting for the stock price to increase, convertible bond holders receive regular, semiannual interest payments from the bonds. Convertible bonds are debt securities until the bond holder elects to convert to stock.
  
  

Effects

• Convertible bonds can have one of two natures. If the stock price is well below the conversion price, the convertible will act like a bond. The bond market value will change with a change of interest rates and the credit rating of the issuer. As the stock price approaches the conversion price, the convertible bond price will reflect the value changes in the stock and the overall stock market. The effect a falling stock price will have on the convertible bond depends on how close the stock price is to the conversion value.
  
  

Considerations

• If the stock value is near or above the conversion price and starts to decline, the result will be a proportional decline in the value of the convertible bond. If the stock price continues to decline, at some point the bond features--the interest payment and future payment of the face value--will stabilize the bond price. The falling stock price may pull the bond price even further if the market believes the company is in danger of bankruptcy, wherein the value of the convertible bond may be destroyed.
  
  

Potential

• If the value of the company stock is declining and the convertible bond is also falling in value, the bond holder should evaluate the financial condition of the issuing company. If it appears the company is strong enough financially to continue the interest payments on the bond, the convertible bond may become a good investment to hold and wait for the stock price to recover. The bond should always be evaluated on the basis of the long-term potential of the stock.