A convertible debt that can be converted into shares shares of common stock is known as a convertible corporate bond. The pricing or conversion ratio is based on a fixed convert price and the par value amount of bonds owned.
If an investor owns $1000 par value of a corporate bond that has a convertible price of 50 can own 20 shares of stock (1000 divided by 50). The pricing of these bonds tends to trade near par, since the price or interest rate risk with these bonds is less because of the conversion feature.
Normally when interest rates rise, bond prices go down. That is true with most bonds. Convertible securities offer investors a way out of the bond into stock of the company. That fact keeps the pricing market fairly stable on these bonds.
Bonds that are issued as convertible bonds usually offer lower interest rates
than comparable corporate bonds because they are more attractive to
investors, due to the conversion factor and the possible investment gain
from the stock price. For the same reason, interest rate changes do not
cause convertible bond prices to fluctuate as much as comparable corporate
bonds prices do, but convertible bond prices fluctuate in relation to the
price of the underlying stock. As the
underlying stock rises in price, so will
the convertible bond, because it becomes more in demand. Why? If the
bond does not increase in value, investors can buy the bond at a low price,
convert the bond to stock, and sell the stock in the open market at a price
that would be higher than the value of the bond. This would be a CONVERTIBLE BOND ARBITRAGE.
A convertible bond arbitrage
can only happen when the bond is at
a discount to stock parity or the
stock is at a premium to bond parity.
As the underlying stock decreases in
price, the bond will decrease as well
because it will be in less demand.
However, the bond will only decrease in
price to the level that would make it competitive, based on interest rate.
The CONVERSION RATIO is the number of shares into which the bond
can be converted. Most convertible bonds state the conversion price, but
sometimes a corporation will simply assign the number of shares of stock
into which the bond is convertible without stating the conversion price.
In instances where a conversion ratio is given, the number of shares that the
bond can convert to will allow you to determine the conversion price.
The definition of parity is when the value of the bond is equal to the value of the common stock on a convertible security. Using the above numbers, if the common stock was selling at $50 a share, a par bond of $1000 is equal (20 shares times 50 = 1000)
If the stock was only selling at $45 a share, the stock value would be $900. The shares would be trading at a discount to parity with the bond or the debt is at a pricing premium parity to the stock.
Convertible bonds can be an attractive investment for portfolios. They offer guaranteed interest and the ability to own shares in the corporation at a fixed conversion price, for as long as you own the debt.
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