BASICS OF CONVERTIBLE BONDS

Investing in a convertible bond is a little like getting two things for the price of one. You not only get the relative security of a bond (along with regular interest payments), you also gain the right to convert the face value of the bond into company stock.

Before you buy a convertible bond, you will want to know the stock price at which you can make this conversion. The price at which a convertible bond can be converted into stock is called its conversion price.

You will also want to know how many shares you can get for your bond. The number of shares you can convert to, as well as their price, is preset at the bond's issue and remains fixed throughout the life of the bond. The number of shares you can exchange a bond for is determined by the bond's conversion ratio. The conversion ratio is found by dividing the face value of the bond by its conversion price.

Taking this a step further, you can determine the value of the shares you can get for each bond if you immediately convert it. Multiplying the bond's conversion ratio by the stock's current market price gives you this answer in the form of the bond's conversion value.

If a bond's conversion price exceeds the share's current market price, the price difference is called a conversion premium. The premium amount is expressed as a percentage of the current share price. It is the additional amount an investor would have to pay to own the convertible bond instead of the stock itself. When stock prices fall, the premium gets bigger and vice versa.

A portion of a convertible bond remains fixed (unlike its conversion value). This portion is called its investment value or bond value. Investment value is determined by the bond's coupon (interest) rate and maturity date.

A convertible bond cannot be converted into stock if its underlying stock price falls below a certain level, called its floor value. The stock price must be equal to or above the convertible's conversion price to make the conversion worthwhile to an investor. At its floor value, the convertible's conversion option becomes worthless and the bond is treated as any other bond, because it still earns fixed interest.