Convertible Bonds Explained
A convertible bond is ostensibly compensatory. The compensation consists of an option accompanying the bond that enables the bondholder to convert it under certain circumstances into shares of the company that issued the bond. The conversion terms will be discussed later in this course.
As will be seen, the option of converting the bond under certain circumstances can be extremely profitable. Unfortunately, however, there is no free lunch in the capital market: This conversion bonus must be paid for. The payment is usually made through a lower coupon for a convertible bond rather than an identical bond with no conversion option.
Convertible Bond Data
In addition to the six standard pieces of information accompanying every ordinary bond, convertible bonds also include the following additional data relating to the conversion option:
Conversion shares - this denotes the type of shares of the company which will be received on the conversion date. This information is very important for a company that has various types of shares.
The conversion ratio - this denotes the number of bonds required to receive a single share.
The conversion dates - this stipulates the dates on which the conversion can be made.
The Immediate Conversion Premium Test
The immediate conversion premium tells us how much more (or less) in terms of percentages the purchaser pays for a share acquired through the purchase of a convertible bond following its conversion into a share, as compared with a share purchased directly on the stock exchange.
[(conversion ratio x bond price/share price) – 1] x 100%
If more than this amount is paid, then the premium is positive.
If less is paid, then the premium is negative.
For example, if the price of a convertible bond is $1.10, then the price of the share on the stock exchange is $2, and the conversion ratio is 2.
[(1.1 x 2/2) – 1] x 100% = 10%.
Whether Buying Convertible Bonds is Worthwhile
Convertible bonds provide their owners with another advantage, in addition to the interest paid by the company. In regard to ordinary bonds, there is no connection between the price of the bond and the share price of the company issuing the bonds. The share price can double in value without affecting the bond price in any sense. In the case of convertible bonds, on the other hand, when the share price rises, it causes a corresponding increase in the price of the convertible bonds.
Assume that the price of Company A’s share on a given date is $2, the price of the convertible bond is $1, and the conversion ratio is 2.
The immediate premium in this case is: [1 x 2/2 – 1] = 0
This means that someone buying the share by converting two convertible bonds pays no more than someone buying the share directly on the stock exchange.
If the share price rises by 20% to $2.40, then the owners of convertible bonds will not agree to sell them for less than $1.20, since they could obtain a share worth $2.40 by converting two bonds to a share.
In this case, the price of the convertible bonds will also rise by 20%, and reach $1.20.
It is customary to say that convertible bonds provide their owners two advantages:
- A floor price - the bonds guarantee the interest and principal whereas the price of a share can decline more steeply.
- The chance of an increase in the bond price caused by a rise in the share price.
These advantages, however, come at a price. The convertible bonds are usually issued on less favorable terms than ordinary bonds (i.e., lower interest).
Appendix 1 - a Change in the Conversion Rate Following a Distribution of Bonus Shares
Bonus shares are distributed free of charge to a company’s shareholders. When a company distributes bonus shares at a given rate, then the conversion ratio should be corrected to enable holders of convertible bonds to receive the same value of shares they would have received had they converted their bonds just prior to the bonus shares having been awarded.
For example, let us assume that the conversion ratio is 2 and bonus shares are distributed at a 200% rate (every shareholder receives two shares for each share that is held).
Holders of convertible bonds must now receive three shares for every two bonds as opposed to receiving one share for two bonds as was the case before the distribution of the bonus shares. This means that the ratio is adjusted to three shares per two bonds, as compared with the previous one share for two bonds.
Explanation: One share before the distribution of bonus shares is worth three shares after the bonus.