Convertible bonds

Convertible bonds

We first learned about convertible securities in the preferred stock chapter. Both preferred stock and corporate bonds can be convertible into common stock of the same issuer. For example, a convertible Ford bond allows the bondholder to convert the bond into Ford common stock.

A conversion feature gives the investor a second potential source of return:

• The bond’s yield provides interest income.
• If the investor converts to stock, they may also earn capital gains if the stock price rises.

When a convertible bond is issued, the issuer sets its conversion ratio and conversion price. In plain English, both describe how many shares of stock you receive if you convert the bond. These terms are set when the bond is originally sold and typically remain fixed for the life of the bond.

The conversion price is mainly used to calculate the conversion ratio. For example:

A convertible bond has a conversion price of $40. What is the conversion ratio?

$\text{Conversion ratio}=\frac{\text{Par}}{\text{conversion price}}$

$\text{Conversion ratio}=\frac{\text{\$1,000}}{\text{\$40}}$

$\text{Conversion ratio}=25:1$

So the conversion ratio is 25:1, meaning one bond can be converted into 25 shares of common stock. For most convertible bond math questions, the conversion ratio is the key number. If the question gives you the conversion price, use the formula above to find the conversion ratio.

If the question provides the conversion ratio, you don’t need to calculate it - you already know exactly how many shares you’ll receive upon conversion.

However, you may also see the reverse: the question gives 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?

$\text{Conversion price}=\frac{\text{Par}}{\text{conversion ratio}}$

$\text{Conversion price}=\frac{\text{\$1,000}}{\text{20}}$

$\text{Conversion price}=\$50$

This is the same relationship as before - conversion price and conversion ratio simply trade places in the formula.

Let’s switch gears and look at how an investor can earn a capital gain by converting.

A corporate bond has a conversion ratio of 10:1 and is purchased for $900

The investor can profit from converting if the common stock price rises above $90. You can think of this as buying a “bundle” of 10 shares for $900. To find the break-even stock price, convert the bond price into a per-share cost:

$\text{Conversion cost per share}=\frac{\text{bond price}}{\text{conversion ratio}}$

$\text{Conversion cost per share}=\frac{\text{\$900}}{\text{10}}$

$\text{Conversion cost per share}=\$90$

If the market price of the common stock rises above $90, the investor would make a profit by 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?

Convertible bonds offer this added upside potential. Because of that conversion feature, they’re typically issued with lower interest rates and trade at lower yields (higher prices) than comparable non-convertible bonds.