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Convertible Securities: Convertible Bonds Explained

A "convertible security" is a security (it may be a bond or a preferred stock) that can be converted into a different security. Typically, it is the holder of the convertibles who decides whether and when a conversion occurs. However, there are cases when the company can determine when the conversion occurs.

What Is a Convertible Bond?

Generally, convertible bonds provide their holder with the option to convert the bond into a predetermined number of shares of stock in the issuing company, typically at some pre-announced ratio.

When convertible bonds are first issued, they act like regular corporate bonds. It is true that usually they have a low coupon rate, but their holder is compensated with the opportunity to convert the bond into common stock which could be beneficial if the price of the underlying stock rises. Yet again, if the stock performs poorly, the holder will have to bear the lower return.

Why would a company issue a convertible bond?

Whenever a company decides to issue a stock, the market may interpret this as an indicator that the company's share price may be overvalued. In order to evade this effect, companies may issue convertible bonds. The holders of the bonds will most likely convert them into equity if the company keeps doing well.

Convertible Bond Features

Just like typical bonds, convertible bonds have their issue date, maturity date (assuming the conversion is never exercised), face value, maturity value, and coupon. However, they also have some unique features, including:

Conversion price - This is the nominal price per share at which the conversion takes place.

Conversion ratio (conversion premium) - This determines the number of shares that can be converted from each bond.

Call features - This is the ability of the bond's issuer to call the bond early for redemption, in other words to forcibly convert it.

Pros and Cons of Convertible Bonds

Proponents of convertible bonds would argue that they give investors the best of both worlds - they offer certain rate of return and the value of the ability to trade the bond into stock if the underlying stock rises.

However, there are certain flaws that you should be familiar with before you decide to invest in convertible bonds:

To start with, typically convertible bonds are callable. This means that the issuer may redeem the bonds at its discretion. And the possibility of forced conversion is only one of the downsides of convertible bonds.

Generally, convertible bonds offer a lower interest rate. In addition, if the stock price declines the bond price will also drop.

Finally, in order to be able to convert the bond, the stock price needs to reach a certain number, which can be pretty high. If you really want to own the stock you may be better off to buy it at its lower price than waiting for it to reach this premium.

To conclude, convertible bonds can be a very good investment. However, do your homework and just make sure you understand the risks involved.

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