A conertible bond is a bond with an embedded conversion option that gives the bondholder the right to convert their bonds into the issuer’s common stock during a pre-determined period at a pre-determined price.
A convertible bond is a hybrid security. In its traditional form, it presents the characteristics of an option-free bond and an embedded conversion option. The conversion option is a call option on the issuer’s common stock, which gives bondholders the right to convert their debt into equity during a pre-determined period (known as the conversion period) at a pre-determined price (known as the conversion price).
Convertible bonds have been issued and traded since the 1880s. They offer benefits to both the issuer and the investors. Investors usually accept a lower coupon for convertible bonds than for otherwise identical non-convertible bonds because they can participate in the potential upside through the conversion mechanism—that is, if the share price of the issuer’s common stock (underlying share price) exceeds the conversion price, the bondholders can convert their bonds into shares at a cost lower than market value. The issuer benefits from paying a lower coupon. In case of conversion, an added benefit for the issuer is that it no longer has to repay the debt that was converted into equity.
However, what might appear as a win–win situation for both the issuer and the investors is not a “free lunch” because the issuer’s existing shareholders face dilution in case of conversion. In addition, if the underlying share price remains below the conversion price and the bond is not converted, the issuer must repay the debt or refinance it, potentially at a higher cost. If conversion is not achieved, the bondholders will have lost interest income relative to an otherwise identical non-convertible bond that would have been issued with a higher coupon and would have thus offered investors an additional spread.