Convertible bonds are a type of corporate bond that can be converted into shares of common stock at some point during the ownership of the bond. Usually, corporate bonds of this type may be converted into common stock once the bond has reached full maturity. However, there are examples of the convertible bond that allow this conversion to take place at some point prior to the point of full maturation.
It is important to note that an investor is under no obligation to actually exchange the bond for a comparable number of shares of common stock. The function of the convertible bond makes this a possibility, but not a necessity. Defined as being a form of junior debenture, the convertible bond simply makes it possible for the bond holder to receive shares of stock rather than realize a cash return on the bond proper.
A convertible bond can be an appealing situation for investors. Generally, a convertible bond issue is considered to be low risk, but still providing the potential to take advantage of a projected increase in the value of the underlying stock. Still, the prospective investor should understand that a convertible bond usually does not pay as high a rate of interest as a conventional bond. This is because of the option to convert the bond into shares of stock and thus realize a greater return from that action.
Generally, the price for the stock is set in the terms and conditions that apply to the purchase of the convertible bond. This means that if an investor holding this type of bond believes that the stock will rise shortly after the bond matures, choosing to receive shares rather than a cash return could be a very smart move. At the same time, if the projection is that the shares will remain flat or even fall below this guaranteed price conversion, the investor would do well to go with the cash return and forgo the option of receiving shares of common stock.
The use of the convertible bond is common in many situations. Money markets and mutual funds are common examples of investing options that will include opportunities with a convertible bond issue. It is also possible to acquire a convertible bond through a broker as a stand alone investment.