Taxable Bonds

Convertible Bonds

Convertible bonds are corporate bonds with a conversion feature that allows an investor to convert his or her bond into a specified number of common shares of an issuing company. A conversion is included in order to promote an issue with a low yield. Convertibles appreciate in value when a company’s stock moves up but are less volatile for a downward trend due to their fixed interest payments and final maturity dates. Convertible bonds suit investors looking for higher yields than common stock and greater appreciation than other classes of corporate bonds. Furthermore, fixed income payments from convertible bonds are safer than dividend payments from equities, and in the event of default are paid ahead of common stock holders. If held to maturity (without conversion), a convertible bond redeems at face value ($1,000). Furthermore, converting a bond to a stock is not a taxable event. In liquidation, convertible bondholders have priority over stockholders for claims on assets. When converting bonds to a stock, a corporation no longer has a commitment to continue backing interest payments: Instead, their taxable income rises by removing the corporation’s debt deduction. In this case, shareholders are diluted as the number of shares outstanding increase thereafter the conversion. When shareholders’ ownership decreases, a corporation loses some control over its affairs. An increase in the number of the shares outstanding reduces current stockholders’ voting rights. Most convertible bonds contain an antidilution clause that allows the conversion ratio to increase and the conversion price to decrease by the percentage of stock dividends or a split. A conversion price indicates the stock price at which a bond can be converted into in order to determine the conversion ratio and/or the amount of shares a bond converts into. The conversion price is stated on the bond certificate or indenture. An investor can determine the conversion ratio by dividing the par value by the conversion price. Before converting into a common stock, an investor needs to find out the conversion parity; that is a common stock price at which a bond can convert into at equal value. When the common stock price is lower than the conversion price, a convertible bond is worth more than the underlying stock. However, if a common stock trades above the conversion price, an investor can profit from converting into a common stock and then selling the shares in the market place for a profit.

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