Convertible bonds

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Convertible bonds are hybrid securities that have both debt and equity features. Like a normal straight bond, the buyer receives coupon payments at the interest rate specified on the bond until maturity, when the company redeems the bond at par. However, the bond holders also have the option to convert the bond's value into the issuing company's shares at an agreed-upon pre-specified ratio.

Advantages and disadvantages for the investor and the issuer

Because of its dual nature as a bond and an equity option, convertible bonds allow investors to participate possibly in the upside gains of the stock while protecting possible downside through the guaranteed continuous coupon payments. Companies have incentive to raise convertible debt, rather than traditional debt, because the interest payments on convertible bonds are usually lower, thus allowing the issuer to lock in a lower long-term financing cost when compared to traditional debt.

However, most convertible bonds are structured as unsecured debt for the issuer, meaning that if the issuing company were to become bankrupt and default on the bond, the buyer of the bond has a lower priority claim on the company's assets, after the secured straight debt holders have been paid off. Therefore, although the possible upside gains on the convertible bond is higher than a normal bond, its default risk is also relatively higher.

Convertible bond terminology

Relevant convertible bond concepts can be separated into two categories due to its dual bond-and-equity nature:

Bond portion

  • Par Price / Par Value: Usually $1000 per bond, the par price of the convertible bond is the cash value of the bond at maturity.
  • Maturity: This is date on which the bond can be redeem for its par price. A convertible bond with a maturity longer than ten years is also known as a convertible debenture.
  • Coupon / Interest Payment: Usually given as an annual percentage, the coupon payment is the steady stream of income paid out to the holder of the bond. For example, a 3.5% convertible bond with a par price of $1000 will give $35 in coupon payments each year.

Equity option portion

  • Conversion Ratio: This gives the ratio at which a convertible bond may be converted into shares of stock. The conversion ratio is always calculated by dividing the par price of the bond with the conversion price, i.e. the price of the stock at conversion. For example, a convertible bond with par price $1000 can be converted into stock at $20/share, which means this bond has a conversion ratio of 50 ($1000 divided by $20).
  • Current Stock Price: The current stock price is used to calculate the value of the equity portion of the convertible bond. For example, if the bond's conversion price is $20/share, then the buyer of the bond will choose to convert the bond into equity if the stock is now $25/share but will hold on to the bond if the stock is below the conversion price.

Valuation of convertible bonds

The valuation of convertible bonds can be quite complex because of its dual nature as a normal bond and as an equity call option. Conceptually, the value of a convertible bond can be calculated in two steps, by first valuing the straight bond portion and then calculating the worth of the call option. A convertible bond that is exactly fair-valued should have its bond piece and equity call option piece add up to exactly its market trading price.

Useful internet resources for calculating the value of a convertible bond

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