Convertible bond
Also known as: convertible debenture
A convertible bond is a corporate bond that the holder can exchange for a fixed number of the issuer's common shares. It pays interest like a normal bond but also lets the investor participate if the company's stock rises.
A convertible bond is corporate debt with an equity option attached. The investor receives regular interest payments and a claim on principal like any bondholder, plus the right to convert the bond into a set number of common shares. That right belongs to the bondholder, not the issuer, and it can be exercised whenever the terms allow.
The math runs off the conversion ratio, which tells you how many shares each bond converts into. A $1,000 par bond convertible at $40 has a conversion ratio of 25 shares (1,000 ÷ 40). Divide the bond's market price by the conversion ratio and you get parity price — the stock price at which the bond and the shares are worth the same. If that bond trades at $1,100, parity is $44 per share; with the stock at $50, converting is worth $1,250 and the bond will trade at or above that level.
Both sides give something up. The issuer sells convertible debt at a lower coupon than comparable straight bonds because the conversion feature has value, but existing shareholders face dilution if conversion happens. The investor accepts that lower yield in exchange for upside in the stock while keeping a bond's downside protection — the bond still has a maturity date and sits ahead of stockholders in liquidation. Many convertibles are also callable, which issuers use to force conversion once the stock has risen.
Convertible bonds are heavily tested. The Series 7, Series 6, and Series 66 all cover the mechanics — computing conversion ratio and parity, deciding whether converting or selling is more profitable, and recognizing that a convertible's price tracks the stock once the shares move above parity.
Key takeaways
- A convertible bond can be exchanged by the holder for a fixed number of the issuer's common shares.
- Conversion ratio equals par value divided by the conversion price; parity price equals bond price divided by the conversion ratio.
- Issuers pay a lower coupon for the conversion feature but risk diluting existing shareholders.
- Investors get equity upside while keeping a bondholder's seniority and maturity date.
- The Series 7, Series 6, and Series 66 test conversion and parity calculations directly.