Convertible bonds can be exchanged for some specified amount of common or preferred stock in the issuing company. At the time of issue, the terms of conversion will be outlined, including the times, prices, and conditions under which it can occur. Most convertible bonds are also callable. This means, in effect, that the company can force bondholders to convert their bonds into stock (called “forced conversion”).
Convertibility affects the performance of the bond in certain ways. First and foremost, convertible bonds tend to have lower interest rates than non-convertibles because they also accrue value as the price of the underlying stock rises. Therefore, convertible bonds offer some of the benefits of both stocks and bonds. Convertibles earn interest even when the stock is trading down or sideways, but when the stock prices rises, the value of the convertible increases. Convertibles, therefore, can offer protection against a decline in stock price. Because they are sold at a premium over the price of the stock, convertibles should be expected to earn that premium back in the first three or four years after purchase. In some cases, convertibles may be callable, at which point the yield will cease.