Pricing Convertible Bonds

A convertible bond's price is written in the company's prospectus when the bond is issued. Convertible bonds are issued by a company in order to raise capital; they are securities that have some of the characteristics of both bonds and stocks. The bonds pay interest to bond holders, but also have a provision that allows a bond holder to convert the bonds into a predetermined number of shares of public common stock of the issuing company. Because a convertible bond provides the right to convert shares into common stock, and thus share in the capital appreciation of the stock, the bonds carry a lower coupon or interest rate. Convertible bonds are complex and have a unique set of terms that must be understood before the investor buys them.

The actual conversion price is the price of the company's stock at which the bond holder can exercise his right to convert his bond into stock. The conversion price is set higher than the stock price at the time that the convertible bonds are issued, so it is not until the stock price goes up to the price agreed on that the bond holder can exchange his bonds for stock.

In addition to the conversion price, a company's bond agreement also lists the conversion ratio, which is the number of stocks that one bond may be exchanged for or converted into. The conversion value is what the stocks are worth at the time that the bond can be exchanged for them. In other words, a convertible bond's value can be calculated by multiplying the current price of the stocks by the number of shares that the bond can be converted to. As the price of the company's stock goes up, the convertible bond's value increases.

Some convertible bonds are callable, which means that the issuing company can call the bonds before the bond's maturity. This is usually done to encourage the bond holders to convert their bonds at a lower price if the company expects their stock prices to increase greatly.

An advantage of convertible bonds is that in the event of the issuing company going bankrupt, holders of convertible bonds will have their claims paid before general stockholders.