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 the bond’s conversion price, which determines its conversion ratio. Both are set when the bond is originally sold and typically remain fixed for the life of the bond.

Conversion price: The price per share at which the bond’s par value is exchanged for common stock.

Conversion ratio: The number of shares of common stock an investor receives when converting one bond.

The link between the two comes from what happens at conversion. The investor hands the bond back to the issuer, which counts the bond at its par value ($1,000) and pays for it in shares, valuing each share at the conversion price. The conversion ratio is simply how many shares $1,000 buys at that price. Because it is based on par, the ratio doesn’t depend on what the investor paid for the bond: a bond bought for $900 converts into exactly as many shares as one bought for $1,000.

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

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

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

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

At $40 per share, $1,000 buys 25 shares, so one bond converts into 25 shares of common stock. The conversion ratio is the number you’ll use in almost every convertible bond question, so if a question gives you the conversion price, find the ratio first.

The same logic works backward. If one bond converts into 20 shares, the issuer must be valuing each share at $1,000 ÷ 20:

A convertible bond has a conversion ratio of 20:1. What is the conversion price?

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

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

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

The rest of the math compares two amounts:

1. What the bond costs in the market
2. What the shares it converts into are worth, called the conversion value (conversion ratio x the stock’s market price)

Let’s follow one bond through both.

A corporate bond has a conversion ratio of 10:1. An investor buys it in the market for $900.

Question 1: What is the investor paying for each share?

The $900 bond can become 10 shares, so buying the bond is like paying $90 for each of those shares. This per-share cost is called the conversion cost per share:

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

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

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

The conversion cost per share is the investor’s break-even point for converting. If the stock trades below $90, converting would turn the $900 bond into shares worth less than $900. If the stock trades above $90, the shares are worth more than the bond cost, and converting creates a profit opportunity.

Question 2: The stock rises. How much does converting earn?

A few years later, the common stock price rises to $120. What is the profit if the investor converts the bond and sells the shares?

Can you figure it out?

Thinking of the bond as a bundle of 10 shares makes the math easier to follow, but the two aren’t the same investment. Until it’s converted, a convertible bond is still a bond: it pays interest, repays par at maturity, and is paid before stockholders if the issuer is liquidated. Common stock offers none of those features.

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.