A convertible bond is a hybrid security combining characteristics of a fixed-income instrument and an equity option. The holder receives regular coupon payments and par value at maturity like any bond, but also holds an embedded option to convert the bond into a specified number of common shares at the conversion price. The number of shares received per bond is the conversion ratio (par value ÷ conversion price).
Because of this equity kicker, convertibles typically carry a lower coupon rate than comparable straight bonds — investors accept less income in exchange for upside participation. The conversion premium is the percentage by which the bond's market price exceeds its conversion value (conversion ratio × current stock price). When the stock price is well below the conversion price, the bond trades primarily on its yield (bond floor); when the stock surges above the conversion price, the bond trades more like equity.
Convertibles offer investors downside protection (the bond floor provides a cushion) with equity upside. Issuers benefit by borrowing at a lower rate and potentially retiring debt via conversion rather than cash repayment.
Forced conversion occurs when an issuer calls the bond at a time when conversion value exceeds the call price, effectively compelling holders to convert rather than accept the lower call price.
> Exam tip: On the Series 7, be ready to calculate conversion ratio and parity price. If par is $1,000 and the conversion price is $25, the ratio is 40 shares. If the stock trades at $30, conversion value = 40 × $30 = $1,200. Know that convertibles are inversely related to interest rates like all bonds, but less so because the equity option partially offsets rate moves.