The conversion option that gives convertible bonds their name ensures that when the bond-issuing company's stock price becomes more attractive, you may convert the bond into stock. Conversion ratios differ from company to company. Terms of the conversion and methods of determining how many shares the conversion will yield are set forth in the indenture you sign when you purchase the bonds.
When stock prices rise, bond prices also rise. When a stock splits, the conversion rate also increases. For example, if your conversion rate is 10 to 1 and the stock splits 2 to 1, your bonds would be valued at 20 to 1. Convertible bonds share qualities of both common stock and bonds. Parity requires values to rise congruently. For example, if your $1,000 bond converts into 50 shares, each share of stock is valued at $20. If stock prices rise to $25 per share, your bond would be valued at $1,250.
When you purchase convertible bonds, the indenture may include various features that make them even more attractive. Sometimes, bond conversions increase over a period of time. For example, your conversion rate may be $50 per share for the first five years, after which you receive an increase that results in a conversion rate of $55. Rates can continue to rise every five years until they reach a threshold or are called for conversion. As an added feature, the original contract usually protects your interests so that a company may not call a conversion if the rates are lower than the initial conversion price you were promised.
Because you gain extra value by purchasing convertible bonds, you earn a slightly lower interest rate on the bonds. As a rule, companies also may call the bonds, forcing you to convert to stock at that time. Businesses may execute a forced conversion to reduce debt, converting bond debt into equity. The corporation doesn’t grow by increasing the number of shares being held. Instead, investors’ holdings in the company are reduced.
As a business owner, you may increase your start-up financing or build liquidity by offering convertible bonds. Most companies that issue convertible bonds expect investors to convert to stocks before the bonds mature, freeing the company from repaying the bonds with interest. As the owner of the company, you also have the right to call the bonds for conversion before your stock prices skyrocket. Early call conversions allow you to add equity to your balance sheet and reduce debt.