Convertible coupon bond

Below, we'll cover the basics of these chameleon-like securities as well as their upsides and downsides.

Accounting for Convertible Bonds | Debt | Notes | Example

As the name implies, a convertible bond gives the holder the option to convert or exchange it for a predetermined number of shares in the issuing company. When issued, they act just like regular corporate bonds, albeit with a slightly lower interest rate. Investors can invest in convertible bonds directly through their brokers or indirectly through a mutual fund. Because convertibles can be changed into stock and, thus, benefit from a rise in the price of the underlying stock, companies offer lower yields on convertibles.

If the stock performs poorly, there is no conversion and an investor is stuck with the bond's sub-par return—below what a non-convertible corporate bond would get. As always, there is a tradeoff between risk and return. Companies issue convertible bonds or debentures for two main reasons.

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The first is to lower the coupon rate on debt. The second reason is to delay dilution. In this case, it can force conversion at the higher share price, assuming the stock has indeed risen past that level.

The conversion ratio—also called the conversion premium—determines how many shares can be converted from each bond. This can be expressed as a ratio or as the conversion price and is specified in the indenture along with other provisions.

The chart below shows the performance of a convertible bond as the stock price rises. Notice the price of the bond begins to rise as the stock price approaches the conversion price.

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At this point, your convertible performs similarly to a stock option. As the stock price moves up or becomes extremely volatile, so does your bond. The exception occurs when the share price goes down substantially. In this case, at the time of the bond's maturity, bondholders would receive no less than the par value.

What it is:

One downside of convertible bonds is that the issuing company has the right to call the bonds. In other words, the company has the right to forcibly convert them. Forced conversion usually occurs when the price of the stock is higher than the amount it would be if the bond were redeemed. But unlike stock, convertible bonds can only fall so far—provide the issuing company remains solvent—since they have a specific maturity date at which time investors will receive their principal.

Supported Interest-Rate Instruments - MATLAB & Simulink

In this sense, convertible bonds have more limited downside than common stocks. The upshot: While convertible bonds have greater appreciation potential than corporate bonds, they are also more vulnerable to losses if the issuer defaults or fails to make its interest and principal payments on time. For that reason, investors in individual convertible bonds should be sure to conduct extensive credit research.

In this way, the convertible bond offered both income and a chance to participate in the upside of the underlying stock. Investors who are prepared to do the appropriate research can invest in individual convertible securities through their broker. A number of major fund companies offer mutual funds that invest in convertibles.

How to Calculate Convertible Bonds

Butman , Hans L. Erickson , Steven Rossiello. The duration vector: A continuous-time extension to default-free interest rate contingent claims Sanjay K. Mcguire , Arthur David Warga.

How it works (Example):

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