Definition: A convertible bond is a debt instrument that the bondholder can trade in to the issuing corporation for a specific number of its common stock shares. In other words, it’s a bond that can be returned to the issuing corporation in exchange for common stock shares.
What Does Convertible Bond Mean?
Convertible bonds offer a nice incentive for investors who want options. These bonds give the bondholders the ability to either hold onto the bond and continue to collect the regular interest payments or convert the bonds to common stock and become owners of the corporation.
Many convertible bondholders purchase these instruments for speculative purposes. Since the number of shares that each bond converts into is set when the bonds are issued to the public, an increase in share price would make the conversion option more valuable.
Let’s look at an example.
Example
Truck Stop, Inc. is issuing 100, 5-year $1,000 convertible bonds to the public. Truck Stop’s current market price per share of common stock is $10 and each $1,000 par value bondcan be converted into 100 shares.
Bob purchases 2 bonds from the corporation and intends to keep them until they mature. Bob holds onto the bonds for the first two years and collects the monthly interest income from the company. In the third year, the stock price increases to $15 a share. This means that Bob can convert his $2,000 bond investment into $3,000 of common stock.
Bob decides to convert the bonds, so Truck Stock retires his bonds and issues 200 new shares for Bob.
Keep in mind, that most convertible bonds don’t have to be converted. Bob could have kept his bonds until they matured and collected the monthly income for five years. These securities just have the conversion option. The bondholders are forced to convert them unless they are callable bonds.
