Convertible corporate bonds offer investors the security of bonds and the potential growth of common stock. To understand how price movements affect these securities, it's important to know the underlying structure, why investors choose convertible bonds and the implications of the conversion feature.
A convertible bond allows investors to exercise a sell option on the underlying shares of common stock. The option can be in the form of a number of shares for each bond, such as 10 shares of common stock for each $1,000 bond, or a set price, such as $100 per share for a $1,000 bond. The cost of having this option is that the bond will pay less interest than nonconvertible, noncallable corporate bonds. The advantage is that when a stock's price rises, the bondholder can convert the bonds into stocks and sell the shares.
In general, the price of a convertible bond will move in tandem with the price of the common stock, so if the stock price falls, the convertible bond price will follow suit. However, the convertible bond has a floor. One of the many advantages of bond ownership for investors is the seniority of bonds in the debt-collection hierarchy. If a company goes bankrupt, its bondholders will be paid before its stockholders. So bonds are considered more secure investments than common stock because you are more likely to get at least some of your money back if the company fails.
When to Exercise
One of the implications of the seniority of convertible bonds to common stock is that if the price of the common stock of the company in which you own convertible bonds falls below the conversion "sell" price, your convertible bond will likely begin to trade like a normal bond. It still retains the value of being a more senior security in terms of who will get paid first. The stock price may be in turmoil because of an external event such as a natural disaster or an internal one like a dismal earnings report. However, as long as the company continues to pay its bills, despite a short-term setback, the price of your convertible bond should remain close to its $1,000 par value. In such a situation, it makes sense to continue to hold the bond because it's retaining value. If the stock price is rising above your conversion sell price, it may be prudent to exercise your conversion option. However, the conversion option is not necessarily absolute for the life of the bond, and converting may be trickier than it seems.
Most convertible bonds also come with a call option, which means the company can repay you the face value of the bond at any time and thereby cancel any options you had to buy the stock at the agreed-upon price or number of shares outlined in the conversion option. This means if you wait too long to exercise your conversion option as a stock price is rising, the company is likely to cancel that option at a moment's notice.
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