Convertible bonds are hybrid securities that have both debt and equity features. Like a normal straight bond, the buyer receives coupon payments at the interest rate specified on the bond until maturity, when the company redeems the bond at par. However, the bond holders also have the option to convert the bond's value into the issuing company's shares at an agreed-upon pre-specified ratio.
Because of its dual nature as a bond and an equity option, convertible bonds allow investors to participate possibly in the upside gains of the stock while protecting possible downside through the guaranteed continuous coupon payments. Companies have incentive to raise convertible debt, rather than traditional debt, because the interest payments on convertible bonds are usually lower, thus allowing the issuer to lock in a lower long-term financing cost when compared to traditional debt.
However, most convertible bonds are structured as unsecured debt for the issuer, meaning that if the issuing company were to become bankrupt and default on the bond, the buyer of the bond has a lower priority claim on the company's assets, after the secured straight debt holders have been paid off. Therefore, although the possible upside gains on the convertible bond is higher than a normal bond, its default risk is also relatively higher.
Relevant convertible bond concepts can be separated into two categories due to its dual bond-and-equity nature:
The valuation of convertible bonds can be quite complex because of its dual nature as a normal bond and as an equity call option. Conceptually, the value of a convertible bond can be calculated in two steps, by first valuing the straight bond portion and then calculating the worth of the call option. A convertible bond that is exactly fair-valued should have its bond piece and equity call option piece add up to exactly its market trading price.