In business, a convertible bond, also called convertible note or convertible bond, is a kind of bond that the holder is able to convert into specified amounts of preferred stock of the issuer or cash equal to a specified amount. It's a very hybrid financial product with equity and debt-like characteristics. It has two distinct parts: debt and equity. It's also referred to as CVs.
Debt-like characteristics of convertible bonds The debt portion of the product is typically the preferred stock of the issuer. It usually pays dividends on a pre-determined rate. This type of CVs are traded on the secondary market. The holder of the preferred stock is not entitled to vote as a common shareholder. This type of bond typically does not have restrictions on trading.
Preferred Stock As a result of the debt-like characteristics of a bond, the conversion ratio for this kind of bond is often low. Generally, there is only one percent or less chance of the issuer selling the bond at a price higher than its conversion ratio. Bond prices can be volatile. A bond may appreciate or depreciate by the time it reaches a particular price. A bond may sell at a price higher than its conversion ratio.
However, a bond will not be convertible unless the price it initially paid (the conversion price) exceeds the present market price of the underlying stock by more than 20 percent. If the price does not reach that level, the bond won't be converted into shares of the issuer's capital stock. A bond's conversion price is determined by determining the present market price of the underlying stock plus the premium paid by the issuer. That figure is then divided by the total number of outstanding shares to determine the bond's conversion price.
The term "call option" refers to the right to purchase (call) a convertible bond at a stated date. The term "put option" refers to the right to sell (put) a convertible bond at a stated date. Both terms mean the same thing. When an investor purchases a call option, the contract gives the investor the right to purchase (buy) a specified amount of equity at a stated date. On the other hand, when an investor purchases a put option, the contract gives him the right to sell (sell) a specified amount of equity at a specified date. These options are usually used to hedge a particular financial instrument such as the debt of the issuer.
Investors who purchase convertible bonds with the option to convert them into shares of the issuer's capital stock use these instruments to lock in a portion of the initial discount they will receive. By locking in the initial discount, they ensure that their initial investment is locked in at a lower price. Bond investors use convertible bond floors to facilitate transactions between them and their fellow bondholders. The flaw makes it possible for investors to trade bonds among themselves without having to deal with a broker. This is especially helpful to small investors who lack the resources to handle transactions on their own.
Convertible bond issues from the proceeds of the issue less the amount of principal (the difference between the current stock price and the conversion ratio). The conversion ratio is the amount by which the difference between the current stock price and the underlying bond's conversion ratio is to the total amount of principal paid to the issuer over the term of the debt. The value of an issue often influences the overall worth of the entire bond. For this reason, investors in these types of issues are advised to invest with caution.
There are two types of reverse convertible securities: call and put. In a call option, the underlying stock has to be the same as the strike price. In a put option, however, the underlying stock must be different from the strike price. A call option is less expensive than a put option. The cost of a call option is the total premium paid to the investor by the bondholder, less any current or realized dividends. This allows the investor to gain access to stocks at a discount.