A convertible bond is a hybrid security. Companies use convertible bonds to borrow money. The bond owner also has the option of converting the bond to shares of common stock anytime during a stated period of time. If the bond owner decides to hold the bond until it matures, the issuing company must pay the par value to retire the debt. Investors can benefit by purchasing convertible bonds, because a bond is less risky than stock. At the same time, a conversion option means the investor can share in the benefits if the stock goes up in value. Companies issuing convertible bonds also benefit because they usually can pay lower interest rates compared to conventional bonds.
1. Read the terms and conditions of the convertible bond. This information appears on the bond itself, called the indenture. In particular, make a note of the time period in which you can exercise the conversion option. Often the option lasts until the bond matures, but not always. If you want to convert the bond to common stock, you must do so before the option expires.
2. Determine the conversion ratio and conversion price. Some bonds state both but may state only one. The conversion ratio is the number of shares you receive if you convert the bond to common stock. The conversion price is the amount you must pay per share. Suppose the conversion ratio is 40. Most corporate bonds have a face value of $1,000. The conversion price equals the face value of $1,000 divided by 40, or $25 per share. Conversely, if you know the conversion price, divide that into the face value to find the conversion ratio.
3. Check the current price of the underlying stock. If the current market price is less than the bond’s conversion price, you will take a loss if you convert the bond to common stock. In this situation, you don’t want to exercise your conversion option. Let’s say the market price of the stock is $20 per share, and the conversion price is $25, making the conversion ratio equal to 40. If you convert, you will receive 40 shares worth $800 in exchange for your $1,000 bond.
4. Decide if you want to convert the bond when the per-share price of the stock rises above the conversion price. Suppose the stock described in Step 3 goes up to $30 per share. If you convert, you exchange the $1,000 bond for $1,200 worth of stock. If that sounds good to you, just call your bond broker and instruct her to exercise your conversion option.
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