A convertible bond is a bond issued by a corporation, generally with a term ranging from twenty five to thirty years. The difference between the standard bond and a convertible bond is that the holder has an option to convert the equity in the bond into shares of common stock in the company at certain predetermined times.
Convertible bonds are comparable to preferred stock over common stock. In the event of any fiscal collapse, holders of convertible bonds are ‘in line’ for repayment before holders of standard issue bonds. Although that doesn’t come into play all that often, it is a good point to be aware of.
The downside of the convertible bonds over standard bonds is that the convertible bonds usually have a lower rate of return than the standard bonds, because their risk is less. If/when the bond holder chooses to convert their bond(s) to common shares there is a price per share conversion price which is detailed in the bond issuance information. Also detailed is the bond conversion rate, which lets the holder know how many shares per bond they are entitled to.
A convertible bond also has something called a ‘parity rate.’ Simply put the parity rate is the point at which the stock price multiplied by the conversion rate is even with the price of the bond. This also takes the conversion price into account. When the price of the stock rises above the parity rate, the bond is generally given a higher value by the issuing company to account for this factor. Raising the value of the bond keeps bond holders more likely to hold the bond rather than converting to common stock. The basic premise of the convertible bond concept is not necessarily to add more common stock to the company, but to raise money for the company.
The advantage to the company is that they can raise funds without diluting the price of the stock at the time of the bond issuance. The advantage to the bond holder is that their holdings are convertible to company stock and that gives a bit more security to them. Obviously, this makes the convertible bonds a safer investment.
The advantage to the investor really is on the back end of the transaction. When the company issues the convertible bonds, they are looking to raise money without issuing more stock and diluting their stock’s price. The investor is willing to take a slightly lower rate of return on their investment with the hope that the convertible bond will exceed parity and they will get more shares of common stock once that price has risen above parity. What you are really looking for in this type of investment is a company that is looking good as a long term investment. If after doing your research you feel that the company is poised for long term growth a convertible bond may be the perfect way to invest in them.