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How They Work
A company may issue a $1,000 bond at 8 percent interest, redeemable for 100 shares of common stock at $10 per share. If the stock is currently trading at $8, the bondholder may wish to continue holding the bonds and collect the 8 percent coupon rate. It makes no sense for the bondholder to exchange a $1,000 asset for an $800 asset. If the stock price should rise to $20, however, the bondholder will likely exchange the bond for 100 shares of stock, in essence paying $1,000 for an asset worth $2,000.
Convertible securities, in effect, are hybrids that offer some of the protections due bondholders -- shelter from liability and senior status in the event of insolvency,
along with a predictable income -- as well as the potential for upside gain if the equity does well.
The issuing company may wish to issue a convertible bond as a sweetener to attract lending dollars. Because convertible bond issuers are generally smaller, less established companies, they would have to pay a prohibitive interest rate in order to issue a conventional bond. Issuing debt as a convertible allows them to pay lower interest rates to borrow money than they otherwise would.
While typically safer than stock in a similar-sized company, convertible bonds tend to be more unstable and prone to default than bonds of more established companies. They also tend to pay lower interest rates than conventional debt, all else being equal.