Convertible Bonds

A convertible bond is a debenture bond with a conversion characteristic where the bond can be traded for a specific number of common shares of the issuing corporation at the option of the convertible bondholder. In very few cases, convertible bonds have been traded for preferred stock or other bond issues.

The issuance of convertible bonds provides corporations of a very popular funding source. Due to the conversion characteristics, convertible bonds are generally subordinated to the other issues of company bonds, and so companies can offer lower coupon rates than issues of non-convertible bonds. This means that companies can issue lower debt quality at lower interest costs.

The following definition may help understand the mechanisms of convertible bonds.

• The conversion price is the common stocks price per share that can be exchanged for the convertible bond.

• The conversion ratio is the number of shares of stocks by which a convertible bond can be exchanged.
• The conversion value is the price of the market of the underlying stock times the number of shares obtained in the exchange.

Let’s imagine that a corporation that wants to collect funds decides that it no longer wants to issue more common stocks because market prices are too low. To raise enough cash, it would have to issue many more shares of common stocks (at the low market price), which would dilute earnings per share for existing shareholders. A straight debt issue would be too costly because  the company would have to match the coupon rate of comparable existing corporate debt issues with similar risk and maturities.

The company, instead, can issue convertible bonds, and due to their conversion feature investors would accept the lowest coupon rates of the issue. The company would have to consider the market’s current price of common stocks to determine the number of shares that every bondholder would receive after conversion.

For example, if the company’s common stock current market price is $18 per share, the company could decide on a $25 conversion price so that bonds can be more desirable to investors.

The conversion price is the price of the underlying common stock at which the convertible bond will be traded.

The conversion ratio is the number of common shares received for each bond. The conversion ratio is the face value of the bond divided by the conversion price. Therefore, the conversion value, is the market price of the underlying stock into which the convertible bond is traded multiplied the conversion ratio.

The following equations show the relationship among the define terms.

Conversion Ratio = number of common shares exchanged for each bond

Conversion Ratio =    Face of value
                                      Conversion Price

Conversion Price = Face value of bond
                                   Conversion ratio

Conversion value = price per share of common stock times conversion ratio

Convertible bonds are valued either related to the conversion value of the stock or as a straight debt.

Actually, many factors are taken into account when valuing a convertible security.

Beginner Money Investing Convertible Bonds and Zero-Coupon Bonds Convertible Bonds The Value of Convertible Bonds as Stock Value of the Convertible Bond as Debt Value of the Convertible Bond as a Hybrid Security Risk of Convertible Bonds, Purchase and Sale The Advantage of Convertible Bonds Disadvantages of Convertible Securities What the Conversion Premium of Discount Means Zero-Coupon Bonds