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A convertible bond is a bond issued by a company that gives the bondholder the option to trade in the bond for shares in the company that issued it . This gives the bondholder both a fixed-income investment with coupon payments as well as the potential to the benefit from a an increase in the company's shares price. The additional value of the conversion option,however, will imply that the coupon on the bond will be lower than that of an equivalent bond with no conversion option.
A convertible bond issue will clearly state the maturity and the coupon on the bond. A specified number of shares of stock are received by the holder of the convertible bond when he or she makes the exchange. This is called the conversion ratio. The conversion price applies to the effective price the holder pays for the common stock when the conversion is effected. The conversion price and the conversion ratio are set at the time the convertible bond is issued. The conversion price should be tied to the growth potential of the company. The greater the potential, the greater the conversion price should be.
In short a convertible bond is a quasi-equity security because its market value is tied to its value if converted rather than as a bond.
