CONVERTIBLES AS BONDS

A convertible bond usually earns lower interest than a regular bond because its value is taken from either its convertible stock price or its bond yield, depending on which is higher. However, a convertible is less affected by changing interest rates because the stock value of the convertible offsets the interest rate fluctuations.

On the secondary market, convertible bond prices generally move in the same direction as their underlying stock. When the share price of the stock increases, the price of the convertible also rises, and it trades like a stock. It is now easier for the investor to convert the bond into shares because there is little or no conversion premium. The market price of the underlying stock is now equal to or more than the convertible's price.

When the underlying stock declines, the convertible is treated more like a straight bond because it would cost an investor too much to convert the bond to shares. The graph below gives you an example of the pricing possibilities of a convertible:

When the convertible's price is before or up to the bond substitute line, the convertible trades as a straight bond. When its price is up to or past the equity substitute line, the convertible has a very small premium, and investors treat it as if it were a stock. Notice that the convertible price can never fall below its bond value.

One of the drawbacks to convertible bonds is high call risk. To reduce its debt, a bond issuer can force bondholders to convert their bonds to stock, or it can buy the bonds back for cash. This is known as calling the bonds or forced conversion.

The volatility of convertible bonds is also generally higher than that of straight bonds because the bond's price is tied to the price fluctuations of its underlying stock.

Now you know how convertible bonds compare to regular bonds. But how do their share prices compare to those of regular stocks?
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