Convertible Bonds

Lesson

Convertible bonds are a type of fixed-income security that allows the bondholder to convert the bond into a predetermined number of shares of the issuing company's common stock. This feature gives the bondholder the potential for capital appreciation if the company's stock price increases. Convertible bonds typically have a lower interest rate than non-convertible bonds due to the conversion feature.

Practice Question #1

Which of the following is a characteristic of convertible bonds?

A) Higher interest rates than non-convertible bonds

B) Cannot be converted into common stock

C) Potential for capital appreciation

D) No fixed maturity date

Select an option above to see an explanation here.

A) Convertible bonds typically have lower interest rates than non-convertible bonds due to the conversion feature. B) Convertible bonds can be converted into common stock. C) Convertible bonds provide the potential for capital appreciation if the company's stock price increases. D) Convertible bonds have a fixed maturity date.

Terms

Convertible bond:: A bond that can be converted into a predetermined amount of the company's common stock at the bondholder's discretion.
Convertible preferred stock:: A type of preferred stock that can be converted into a predetermined number of common shares at the holder's discretion.
Conversion ratio:: The number of shares of common stock that a bondholder receives upon converting a convertible bond.
Conversion price:: The price at which a convertible bond can be converted into common stock.
Conversion premium:: The difference between the convertible bond's market and conversion prices.

Practice Question #2

What is the conversion premium of a convertible bond with a market price of $1,100 and a conversion price of $1,000?

A) $100

B) $200

C) 300

D) 400

Select an option above to see an explanation here.

A) The conversion premium is the difference between the convertible bond's market price and the conversion price, which is $1,100 - $1,000 = $100. B) Incorrect calculation. C) Incorrect calculation. D) Incorrect calculation.

Do Not Confuse With

Preferred stock:: A type of equity security with a fixed dividend rate and priority over common stock in the payment of dividends and liquidation of assets.
Callable bond:: A bond that the issuer can redeem before its maturity date.

Practice Question #3

Which of the following provisions allows a bondholder to sell a convertible bond back to the issuer before its maturity date?

A) Call provision

B) Put provision

C) Conversion provision

D) Redemption provision

Select an option above to see an explanation here.

A) A call provision allows the issuer to redeem the bond before its maturity date. B) A put provision allows the bondholder to sell the bond back to the issuer before its maturity date. C) A conversion provision allows the bondholder to convert the bond into common stock. D) A redemption provision is another term for a call provision.

Historical Example

In the late 1990s, many technology companies issued convertible bonds to raise capital. As the stock prices of these companies soared during the dot-com bubble, many bondholders converted their bonds into common stock, realizing significant capital gains. However, when the bubble burst, the stock prices of these companies plummeted, and the value of the converted shares decreased significantly.

Practice Question #4

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Example Series 65 Example Practice Question

Real-World Example

A company issues a convertible bond with a par value of $1,000, a coupon rate of 4%, and a conversion ratio of 20. This means the bondholder will receive $40 in annual interest payments and can convert the bond into 20 shares of the company's common stock. If the stock price increases from $50 to $60, the bondholder can convert the bond into shares worth $1,200, realizing a capital gain of $200.