Convertible Bonds
Convertible bonds are bonds that can be converted into shares of common stock (and sometimes preferred stock) at a fixed conversion ratio, which is stipulated in the bond indenture.
The conversion price is usually set at a premium to the market price of the common stock at the time that the bonds are issued. For example, if the common stock is trading at $20 per share, the convertible bonds may be issued at a conversion price of 25% above the market price. This would be $20 x 1.25 = $25 per share. To get the conversion ratio, which is the number of shares of stock an investor receives for one bond, the bondholder can divide the conversion price into the par value of the bond. In this case, $25 into the $1,000 par value = 40 shares per bond.
Suppose the convertible bond has a conversion ratio of 40 and the issuer’s stock is currently selling at $30. The conversion value of the bond is 40 x $30 = $1,200. If the bond happens to be selling at $1,200, it is said to be at conversion parity. A price of a convertible bond will never vary far from its conversion parity because if it did, many investors would try to profit from the difference between a bond’s conversion value and its selling price. This investing strategy of profiting from differences in prices across markets is called arbitrage. To illustrate, suppose a convertible bond has a conversion value of $1,200 but is selling at $1,160. An arbitrageur (a fancy word for an investor who wants to take advantage of this difference) purchases the bond and immediately converts it, making a risk-free $40 profit. Because there are always arbitrageurs who will make a profit by doing this in quantity, bond prices never vary far from parity.
This convertibility feature means that the price of a convertible bond is usually tied to the price of the issuing company’s common stock, allowing the bondholder to participate in the company’s growth. While convertible bon