What is a Convertible Bond?

A convertible bond is a bond that can be converted to stock using a predetermined conversion ratio. The conversion option is usually available only at set intervals, and conversion is at the discretion of the bondholder. The presence of conversion rights typically reduces the interest cost of such a bond, since investors assign some value to the conversion privilege. Because a convertible bond has features of debt (since it is a bond) and equity (since it can be converted into stock), it is considered a hybrid security.

Advantages of a Convertible Bond

A convertible bond is valuable to an investor, who is protected against a decline in his investment by the interest payments made on the bond, while also retaining the upside potential of an increase in the price of the stock into which the bond can be converted. If the price of the issuing company's stock does not increase, then the investor does not convert his bond holdings into shares, and instead continues to receive interest payments.

The chief benefit to a company of issuing convertible bonds is the reduced interest rate, but this is at the increased risk that the bonds will actually be converted into stock, which will dilute the retained earnings allocable to the company's existing shareholders. Also, depending on the circumstances, convertible bonds can dilute the earnings per share that a publicly-held company reports.

Disadvantages of a Convertible Bond

The main disadvantage of a convertible bond is that an investor will likely experience a lower yield than would be the case with other investment types. This is a particular concern if the issuer’s stock price never attains the conversion price set for the bond, in which case the investor will continue to earn the lower interest rate on the bond through its maturity date.