We first learned about convertible securities in the preferred stock chapter. Both preferred stock and corporate bonds can be convertible into stock of the same issuer. For example, a convertible Ford bond would allow the bondholder to convert their bond into Ford stock at any time.
Conversion features provide the investor with another way to make money on their bond. The bond’s yield provides a return, and additionally, the investor can make capital gains on the stock if they convert.
When a convertible bond is issued, the issuer sets its conversion ratio and conversion price. In plain English, both tell the investor how many shares of stock are received if the bond is converted. They are set when the issuer originally sells the bond and typically stay fixed through the life of the bond.
The conversion price is only useful in finding the conversion ratio. For example:
A convertible bond has a conversion price of $40. What is the conversion ratio?
Doing some quick math provides a *conversion ratio of 25:1 (one bond can be converted into 25 shares of common stock). The conversion ratio is important for any convertible bond math-based question. If the conversion price is provided in the question, use the formula above to find the conversion ratio.
If the question provides the conversion ratio, then there’s no need to do the conversion ratio formula. It tells you exactly how many shares are received when the bond is converted.
However, it’s possible you see a question that provides the conversion ratio and asks for the conversion price. For example:
A convertible bond has a conversion ratio of 20:1. What is the conversion price?
As you can see, it’s very similar to the conversion ratio formula. Conversion price trades places with conversion ratio, and that’s it!
Let’s switch gears and learn how an investor may make a capital gain from converting their bond.
A corporate bond has a conversion ratio of 10:1 and is purchased for $900
The investor could make a profit on the conversion if the common stock price were to rise above $90. They’re basically buying a “pack of 10 stocks” for $900. Break it down on a per-share basis:
If the market price of the common stock rises above $90, the investor would make a profit from converting.
A corporate bond has a conversion ratio of 10:1 and is purchased for $900. After a few years, the common stock price rises to $120. If the bond is converted and the common shares are sold, what is the profit?
Can you figure it out?
Step 1: factor in bond purchase
Step 2: find the conversion value
Step 3: compare conversion value to the original purchase
As you can see, convertible bonds provide an extra potential for return. Because of this, convertible bonds are sold with lower interest rates and traded at lower yields (higher prices) in the market.
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