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What are convertible bonds?
Convertible bonds are a hybrid of straight corporate bonds and common stock. Like a corporate bond, convertible bonds offer the investor guaranteed income in the form of interest accrued from the initial investment.
Convertible bonds give investors the option to convert the bond to common stock at their discretion. As a result, convertible bonds offer higher returns than common stock but lower returns than non-convertible corporate bonds.
Corporate bonds are essentially IOUs. Investors lend money to a company, which issues a bond. In return, the company has a legal obligation to pay interest on the money borrowed for a set amount of time.
When the bond matures, the company returns the principal to the investor as well. Corporate bondholders do not own a piece of the company and are not permitted to make decisions or vote at shareholders’ meetings.
Additionally, the value of a corporate bond remains the same and does not increase or decrease, depending on the success of the company.
Maturity rates for corporate bonds vary from as little as three years to 10 years or more. The longer it takes the bond to reach maturity, the greater its risk and the higher its interest rate.
Convertible bonds provide a reliable income with guaranteed payments and also give the investor the option to take part in the profits of the company.
Before issuing bonds, the company determines the conversion rate, or how many shares of stock the investor can receive if the bond is converted after a set date.
Interest rates for convertible bonds are typically lower than other types of corporate bonds because of the added advantage of a conversion clause.
Convertible bonds example
When convertible bonds are issued, they come with a set interest rate. On a certain date, they can be converted into a company’s stock, using a specific conversion ratio that specifies the number of shares you get per bond. If the stock trades low enough that converting at those terms would mean taking a loss, the investor instead can get the bond’s par value at a generally low interest rate.
Do you know the basics of bonds? This Bankrate story will give you a rundown.