How Convertible Bonds Work, How They Are Valued, and What the Exam Tests

A convertible bond is a corporate bond that the holder can exchange for a set number of the issuing company’s common shares. It pays interest like a normal bond, usually at a lower rate, but it also gives the investor the chance to share in the company’s growth if its stock price rises.

That combination is why convertibles are often called hybrid securities. They sit between bonds and stocks, offering some of the protection of a bond and some of the upside of equity, and the Series 65 tests how they are priced, how conversion works and who they suit.

This guide covers how convertible bonds work, the key terms and calculations, why companies issue them, the risks, the main variations, worked examples, a client scenario, the exam traps candidates fall for and five practice questions with explanations. Preparing for your exam? Explore every FRC video playlist and pick out the exam topics you want to master first, with exam traps called out in every topic.

What Makes a Bond Convertible

A standard corporate bond pays interest until maturity and then repays its face value, usually $1,000. A convertible bond does the same, but it adds a conversion feature: the right to exchange the bond for a fixed number of the issuer’s common shares.

The holder chooses whether and when to convert, usually at any time before maturity. If the stock price rises far enough, converting can be worth more than holding the bond; if it does not, the investor simply keeps the bond and collects interest.

That right has value, which is why investors accept a lower interest rate on a convertible than on a similar non-convertible bond from the same company.

Where Convertibles Appear on the Series 65

Convertible securities appear in the investment vehicle sections of the Series 65 and on the SIE. Questions test conversion ratios, conversion prices, parity and the trade-offs that make convertibles suitable or unsuitable for particular clients.

FRC’s Series 65 Exam Preparation course covers fixed income and equity securities, including hybrid securities and the calculations behind them, and the exam requires no sponsor. The SIE Examination Preparation course covers corporate bonds and convertible features as part of the exam you can pass before you are hired.

Every FRC course can be spread across interest-free monthly payments, so cost is no reason to delay. Convertible calculations follow fixed formulas, which makes them some of the most dependable marks on the exam once you have practiced them.

The Key Terms

The conversion ratio is the number of shares an investor receives for each bond. The conversion price is the share price at which conversion effectively happens, and the two are linked: the conversion price equals the bond’s par value divided by the conversion ratio.

A bond with a $1,000 par value and a conversion ratio of 25 has a conversion price of $40. If the stock trades above $40, the shares received on conversion are worth more than $1,000.

Conversion value is what the bond would be worth if converted today: the conversion ratio multiplied by the current share price. These terms are fixed in the bond’s indenture, the legal agreement that sets out its terms.

Parity and Conversion Premium

A convertible is at parity when its market price equals its conversion value, meaning there is no advantage to converting or holding at that moment. FRC’s guide to how to calculate conversion parity works through the parity calculations step by step.

In practice, convertibles usually trade above their conversion value. The difference is called the conversion premium, and it reflects the value of the bond’s interest payments, its repayment at maturity and the option to convert later.

If a convertible trades below its conversion value, traders can buy the bond, convert it and sell the shares for an immediate profit. That arbitrage tends to close the gap quickly, which is why convertibles rarely trade below parity for long.

The Bond Floor

A convertible’s value has a floor. Even if the stock price collapses, the bond is still worth at least what it would be worth as an ordinary bond, its investment value, based on its interest payments and repayment at maturity.

That floor is what gives convertibles their downside protection. When the stock falls, the convertible’s price usually falls less, because it starts to behave like a bond.

The floor is only as strong as the issuer’s credit. If the company runs into serious financial trouble, both the stock and the bond can fall sharply, and the protection can disappear.

How Convertibles Behave as the Stock Moves

When the share price is far below the conversion price, the convertible behaves mostly like a bond. Its price moves with interest rates and the issuer’s credit quality, and the conversion option is worth relatively little.

As the share price rises toward and above the conversion price, the convertible behaves more and more like the stock. Its price rises with the shares, and the bond features count for less.

This changing behavior is the appeal for investors. A convertible tends to capture much of a stock’s rise while falling less than the stock in a decline, though never all of the upside or none of the downside.

Why Companies Issue Convertibles

Companies issue convertibles mainly to borrow more cheaply. Because investors value the conversion option, the company can pay a lower interest rate than it would on ordinary bonds.

Growth companies with high share price volatility and limited credit histories often find convertibles especially attractive. The conversion feature makes their debt easier to sell, and if the shares rise and investors convert, the company never has to repay the debt in cash.

The cost is potential dilution. If bonds are converted, new shares are issued, and existing shareholders own a smaller percentage of the company. Analysts track this through diluted earnings per share, which assumes convertibles are converted.

Forced Conversion Through a Call

Most convertibles are callable, meaning the issuer can redeem them early at a set price. Issuers often use that right to force conversion when the stock price has risen well above the conversion price.

When the company calls the bonds, investors must choose between accepting the call price in cash or converting into shares. If the shares are worth more than the call price, every rational investor converts, so the company has turned its debt into equity.

That limits how long investors can enjoy the bond’s interest while the stock rises. Call protection periods, during which the bond cannot be called, are an important term to check before buying.

Anti-Dilution Protection

Convertible indentures usually include anti-dilution provisions. If the company splits its stock or pays a stock dividend, the conversion ratio is adjusted so that bondholders are not disadvantaged.

In a two-for-one stock split, for example, a conversion ratio of 25 would become 50, and the conversion price would fall by half. The conversion value of the bond stays the same.

Exam questions sometimes test this adjustment. Remember that the goal is to keep the bondholder’s position unchanged, not to improve it.

Where Convertibles Rank in a Bankruptcy

Convertible bonds are debt, so in a liquidation they rank ahead of preferred and common stock. Many convertibles, however, are subordinated, meaning they rank behind the company’s senior debt.

That ranking affects their risk. A subordinated convertible issued by a weaker company can carry significant credit risk, even with its conversion feature.

FRC’s guide to common stock vs preferred stock explains the full liquidation order, including where convertible preferred stock sits alongside convertible bonds.

Variations: Mandatory Convertibles and CoCos

Mandatory convertibles must convert into shares at or before maturity, rather than giving the investor a choice. They usually pay a higher income to compensate for the lack of choice, and the number of shares received often depends on the share price at conversion.

Contingent convertible bonds, often called CoCos, are issued mainly by banks and convert into equity, or can be written down, if the bank’s capital falls below a set level. They are designed to absorb losses in a crisis, and investors in some bank capital instruments of this kind have lost their entire investment.

Convertible preferred stock works like a convertible bond but is equity rather than debt. It pays dividends rather than interest and ranks below all of the company’s bonds.

How Investors Access Convertibles

Individual convertible bonds often trade in large minimum amounts and are mostly bought by institutions. Many individual investors gain exposure through mutual funds and ETFs that hold a diversified portfolio of convertibles.

Hedge funds also use convertibles in a strategy called convertible arbitrage, buying the convertible and selling short the issuer’s stock to profit from pricing gaps. FRC’s guide to private equity vs hedge funds vs venture capital explains how hedge fund strategies differ from other private funds.

Whichever route an investor chooses, the same core factors apply: the issuer’s credit quality, the conversion terms, the call features and the price paid relative to conversion value.

How Conversion Is Taxed

Converting a bond into the same issuer’s common stock is generally not a taxable event under US tax rules. The investor’s cost basis in the bond carries over to the shares received.

Interest received while holding the bond is taxed as ordinary income each year. When the shares are eventually sold, the gain or loss is calculated from that carried-over basis.

FRC’s guide to what cost basis is explains how basis is tracked and why it determines the tax owed on a sale.

Comparing Convertible and Non-Convertible Bonds

The table below summarizes the main differences.

Worked Example: Conversion Value and Premium

A convertible bond has a $1,000 par value and a conversion ratio of 20, so its conversion price is $50. The company’s stock is trading at $45, and the bond is trading at $1,050.

The conversion value is 20 multiplied by $45, or $900. The bond’s market price of $1,050 is $150 above its conversion value, a conversion premium of about 16.7%.

If the stock rises to $60, the conversion value becomes $1,200. The bond would then trade close to or above $1,200, driven mainly by the stock.

Worked Example: Parity Price of the Stock

Using the same bond, suppose it trades at $1,100. The parity price of the stock is the bond price divided by the conversion ratio: $1,100 divided by 20, or $55.

If the stock trades at $55, converting is worth exactly the same as holding the bond. Above $55, the shares received would be worth more than the bond’s market price.

Exam questions frequently ask for this calculation. Divide the bond’s market price by the conversion ratio to find the stock’s parity price, or multiply the stock price by the ratio to find the bond’s parity price.

Client Scenario: Income With Upside

A client nearing retirement wants some income but is also interested in growth, and asks an investment adviser representative about a convertible bond from a technology company. The bond pays a lower interest rate than the company’s ordinary bonds.

The adviser should explain the trade-off: the client gives up some income for the chance to share in the stock’s gains, while keeping some downside protection from the bond floor. The adviser should also check the issuer’s credit quality, whether the bond is subordinated, its call terms and how much of the client’s portfolio would be exposed to a single company.

A suitable recommendation depends on the client’s income needs, risk tolerance and diversification. As a fiduciary, the adviser must put the client’s interests first; FRC’s guide to fiduciary standard vs suitability standard explains what that duty requires.

The Exam Traps

The first trap is the formula direction. The conversion price equals par divided by the conversion ratio, while conversion value equals the ratio multiplied by the current share price.

The second trap is the interest rate. Convertibles pay a lower rate than comparable non-convertible bonds, because investors pay for the conversion option with lower income.

The third trap is the effect of conversion on shareholders. Conversion increases the number of shares outstanding and dilutes existing owners. The fourth trap is ranking: convertible bonds are debt and rank ahead of all stock, but many are subordinated to senior debt.

A Memory Aid

Think of a convertible bond as a bond with a ticket attached. The bond pays you while you wait, and the ticket lets you swap into the company’s shares if they become worth more than the bond.

You pay for the ticket by accepting a lower interest rate, and the company can force you to use it by calling the bond once the shares have risen.

Practice Questions

Question one: a $1,000 par convertible bond has a conversion price of $40. What is its conversion ratio? The answer is 25 shares, because $1,000 divided by $40 equals 25.

Question two: a convertible bond has a conversion ratio of 20, and the stock trades at $48. What is the bond’s conversion value? $960, because 20 multiplied by $48 equals $960.

Question three: a convertible bond trades at $1,200 and has a conversion ratio of 30. What is the parity price of the stock? $40, because $1,200 divided by 30 equals $40.

Question four: why do convertible bonds usually pay a lower interest rate than non-convertible bonds from the same issuer? Because investors receive the right to convert into shares, and they accept lower income in exchange for that potential upside.

Question five: what happens to existing shareholders when convertible bonds are converted? Their ownership is diluted, because the company issues new shares to the converting bondholders.

Related Questions

Convertible bonds connect closely to several other Series 65 topics. FRC’s guide to callable vs non-callable bonds explains the call features that let issuers force conversion, and the guide to investment-grade vs high-yield bonds covers the credit quality that underpins a convertible’s bond floor.

Together with the conversion parity and stock guides linked above, they give you a complete picture of how hybrid securities are structured, priced and recommended.

Get Exam-Ready

Convertible bonds are among the most dependable marks on the Series 65 once the conversion formulas and trade-offs are clear. The FRC video playlists linked at the top of this guide cover every exam section, with the traps to look out for in each one.

The FRC dictionary is more than a dictionary. It is a library of explainer videos, written explanations and on-page quizzes covering the FINRA and SEC rules you are tested on, so you can open any rule and go deeper whenever a question catches you out.

Study With FRC

FRC’s programs and memberships are open to everyone. Whether you are preparing for the Series 65, the SIE or both, structured exam preparation turns topics like conversion ratios and parity into marks you can rely on.

FRC’s Professional Membership adds verified progress and a Digital Profile, so when you apply for roles, employers can see your exam progress and the knowledge you are building, not just read about it on a resume.

Your Next Step

A convertible bond pays interest like a bond and can be exchanged for a fixed number of shares, giving investors downside protection and a share in the stock’s upside in return for a lower interest rate. Its value depends on the conversion ratio, the stock price, the issuer’s credit and its call terms.

Master the conversion price, conversion value and parity formulas, and you will be ready for every version of this question the exam can ask.