I. Convertible Bond. A convertible bond is one which is convertible into the company's common stock. The conversion option to the bond is exerciseable when and if the investor wants to do it. The conversion ratio varies from bond to bond. The terms of conversion are set forth in the indenture. The exact number of shares or the method of determining how many shares the bond is converted into is printed in the indenture.

Many times the indenture will tell you how many shares of stock the bond is convertible into. For instance, it might say that it is convertible into 20 shares. Therefore, the conversion ratio is 20:1. Unfortunately, it's not always that easy. For instance, the indenture might state the conversion price. The conversion price is the price per share that the company is willing to trade their shares of stock for the bond. For example, if the indenture states that the conversion price is $50 per share, the bond is convertible into 20 shares of stock. You divide the par value (usually $1,000 for corporate bonds) by the conversion price. Occasionally, the indenture might state that the conversion ratio will change through the years. For example, the conversion price might be $50 for the first five years, $55 for the next five years, and so forth. There are also anti-dilutive features to the conversion feature. If the stock were to split 2 for 1, and the conversion ratio was 20 to 1 prior to the split, after the split, the conversion ratio would be 40 to 1. A stock dividend would also have the same effect. A stock split would also reduce the conversion price.

Because convertible bonds have a little something extra, the right to convert to common stock, that little something extra costs the bond holder. The bond will usually carry a slightly lower interest rate. If the stock price rises, the bond price will also rise. Since most convertible bonds are also callable, the company can force the bond holders to convert the bonds to common stock by calling the bonds. This is known as 'Forced Conversion'. When a bond is converted to common stock, the corporate debt is reduced. What was formerly debt has now been converted to equity. Of course, converting debt (bonds) into stock (equity) has the effect of diluting the equity. The company didn't get any larger with the additional stock. But each stockholder's piece of the pie got smaller. If the company's stock declines to a price which makes the convertible feature of the bond worthless, as long as the company is solvent, the bond will trade based on its yield - like any other bond. There is a price level to which a bond will fall and fall no further as long as the company can pay its interest and the principal upon maturity.

One other term to know is 'Parity'. If the $1,000 convertible bond is convertible into 50 shares of stock, the parity price of the stock is $20. If the stock moves up to $25, for the stock and bonds to be at parity, the bonds would have to be trading at $1,250. A convertible bond provides the performance attributes of common stock and a bond. These securities typically pay a semi-annual coupon of 4.00% to 5.00%. The security is typically a subordinated debenture with a fixed principal amount and time to maturity with a right to convert into common stock based on its conversion ratio. The upside of the convertible comes from its common stock component, while the downside protection comes from the cash coupon, fixed maturity, and status in the capital structure which is senior to common and preferred stock.

II. Convertible Preferred. A convertible preferred also has features similar to a convertible bond. However, convertible preferred stock is subordinated to debt of the issuing company. It typically offers a coupon of 6.00% to 7.00%. A convertible preferred typically pays a cash coupon on a quarterly basis, and is also perpetual or with a long maturity.

III. Valuation: For equity oriented investors, convertibles can be viewed as either a Stock plus Put, or Bond plus Call.

A. Stock plus Put. A convertible security can be viewed as a stock plus a put. The upside of the convertible comes from the underlying stock. The higher the price of the underlying stock goes, the higher the convertible price should go. The downside protection of the convertible comes from its higher yield, fixed maturity value, and status in the capital structure, which all combine to give the security downside protection.

B. Stock Alternative. At very high prices, the convertible still should provide a higher current yield than its underlying common stock and have a low premium. The combination of the higher yield and low premium results in a low breakeven time. The breakeven time is the time it would take a buyer of a convertible to recover the premium paid for it. Low breakeven convertibles typically have the most equity sensitivity, and given the yield advantage, it is not unusual for a convertible with this characteristic to outperform the common on a total return basis.

C. Bond plus Call. A convertible can also be viewed as a bond plus a call. In this case the upside of the convertible comes from the call represented by the conversion feature. Moreover, the downside protection also comes from the bond attributes of the security, including the generally higher yield, fixed maturity value, and place in the capital structure.

For a convertible bond calculator, see Numa

IV. Some Definitions (from Campbell Harvey's Glossary)

Conversion feature Specification of the right to transform a particular investment to another form of investment, such as switching between mutual funds or converting preferred stock or bonds to common stock.

Conversion parity See: Market conversion price

Conversion parity price Related: Market conversion price

Conversion parity/value Common stock price at which a convertible bond can become exchangeable for common shares of equal value; value of a convertible bond based solely on the market value of the underlying equity. Par value + conversion ratio.

Conversion premium The extent by which the conversion price of a convertible security exceeds the prevailing common stock price at the time the convertible security is issued.

Conversion price Dollar value at which convertible bonds, debentures, or preferred stock can be converted into common stock, as specified when the convertible is issued.

Conversion ratio Relationship that determines how many shares of common stock will be received in exchange for each convertible bond or preferred stock when a conversion takes place. It is determined at the time of issue and is expressed either as a ratio or as a conversion price from which the ratio can be figured by dividing the par value of the convertible by the conversion price.

Conversion value The value of a convertible security if it is converted immediately. Also called parity value.

Market conversion price  Also called conversion parity price, the price that an investor effectively pays for common stock by purchasing a convertible security and then exercising the conversion option. This price is equal to the market price of the convertible security divided by the conversion ratio.

Par value  Also called the maturity value or face value; the amount that an issuer agrees to pay at the maturity date.

V. Some Variations

Mandatory Convertibles (PEPS). PEPS, or Participating Equity Preferred Shares, are a type of convertible security that is designed to provide investors with high current income along with high equity-like participation in the underlying stock. PEPS usually provide a coupon of 6.00% to 8.00% and are issued with relatively low premiums of 18% to 23%. The PEPS coupon is usually paid quarterly. These securities typically mature in 3 to 5 years, are typically listed, and are usually call protected for most of their life.

Convertible adjustable preferred stock (Caps) The interest rate on caps is adjustable and is pegged to Treasury security rates. They can be exchanged at par value for common stock or cash after the next period's dividend rates are revealed

PHONES, ZONES and ZENS. These securities are usually issued at the same price as the common with an exchange premium of 5.26%. They typically have a yield that is 1.50% to 2.00% greater than the common dividend, and in most cases this coupon is subject to any additional common stock dividend distribution. PHONES typically have maturities of 30 years. These securities can be exchanged at any time into a cash value equal to 95% of an average price of the underlying common stock over a period of trading days. For taxable investors, these securities do have a negative phantom tax implication. These securities are typically callable at any time at a call price equal to the higher of the issue price or the market value of the underlying common stock, plus a coupon make whole that gives holders any unpaid coupons for the first three years of the security’s term.

Source: Adapted from Equity Analytics and Bloomerg and Morgan Stanley's convertbond.com

Heres's a case study and the details of a convertible bond issued by Nextel.