Investing in corporate bonds is riskier that investing in government bonds or guaranteed investment certificates (GIC). Therefore, in order to attract investors, corporate bond issuers have to pay a higher interest on the bonds than investors could get from other less risky investments. The required return increases even more for smaller and less well established corporations. On way to reduce the required return is to add extra features and benefits to a corporate bond. One of these features is the conversion privilege.

A convertible bond allows the holder to exchange the bond for a specified number of common shares of the issuing company at a specified date or a set of dates. The conversion price which is calculated as the face value of the bond divided by the number of common shares that the investor can get for the bond is usually lower than the current market price of the common share. Therefore, the immediate value of the conversion privilege is zero. This way, the issue is able to pay lower interest to the bond holder without giving up any value immediately.

The value of the conversion privilege for the investor is in the possibility that the stock price may increase in the future. No matter how high the stock price may be at the conversion date, the investor will be able to essentially buy the share at a specified fixed price by converting the bond with a fixed face value. A conversion feature make the boring investment in bonds much more exciting by giving the investor an opportunity to participate in the stock market, while at the same time giving this investor a degree of safety of a bond investment. If you want the best of both world, convertible bonds is the way to go. But as with everything in life, you will have to pay for these benefits in the form of a lower coupon rate.

Nikolay Sisan is a Certified Financial Planner and freelance writer in Vancouver.