Convertible bonds are a hybrid investment, combining features of both stocks and bonds. Like all bonds, convertibles pay a fixed interest rate for the bond's life, with the principal returned at the end of the bond's term. However, convertible bonds can also be exchanged for a specific number of shares of the issuing company's common stock.
The bond's interest payments are typically higher than the dividends paid on the common stock, but the interest rate is usually lower than that on nonconvertible bonds. However, the ability to convert to common shares allows investors to participate in share price increases without as much exposure to share price decreases. Convertibles do not decline as much as the common shares, because the bond retails a market value equal to comparable bonds paying the same yield, which acts as a floor for the convertible's value.
When issued, the convertible bond's value exceeds the common stock's price by an amount known as the conversion premium, which changes as the stock price changes. Most convertibles can be called back by the issuer at a specific price. These call provisions are typically used by the issuer to force investors to convert the bond to common stock so the debt obligation can be eliminated.
Since they are a hybrid investment, convertible bonds can be difficult to evaluate. You should only invest in a convertible if you like the underlying stock.