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 Motor Co. bond would allow the bondholder to convert their bond into Ford stock at any time. Conversion features give investors another way to make money on bonds. The bond’s yield provides a return, and additionally, the investor can make capital gains (buy low, sell high) on the stock if they convert.
When a convertible bond is issued, the issuer sets its conversion ratio and conversion price, which determine the number of stock shares received if the bond is converted. Both generally stay fixed through the life of the bond.
In some scenarios, the conversion price and ratio could change if the issuer performs certain actions (like a stock dividend or split). This concept is unlikely to be tested on the SIE exam.
The conversion price is only valuable for finding the conversion ratio. For example:
A convertible bond has a conversion price of $40. What is the conversion ratio?
Conversion ratio=conversion pricePar
Conversion ratio=$40$1,000
Conversion ratio=25:1
Quick math provides a conversion ratio of 25:1 (one bond can be converted into 25 shares of common stock). The conversion ratio is essential for any convertible bond math-based question. Use the formula above to calculate it if the conversion price is provided in the question.
If the question provides the conversion ratio, there’s no need to perform the conversion ratio formula. It tells you exactly how many shares are received when the bond is converted. However, you may encounter 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?
Conversion price=conversion ratioPar
Conversion price=20$1,000
Conversion price=$50
As you can see, it’s very similar to the conversion ratio formula. Just switch out the conversion ratio for conversion price, 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 profit from the conversion if the common stock price rose above $90. They’re basically buying a “10-pack of stocks” for $900. Let’s break it down on a per share basis:
Conversion cost per share=conversion ratiobond price
Conversion cost per share=10$900
Conversion cost per share=$90
If the market price of the common stock rises above $90, the investor will profit from converting.
A corporate bond maintains a conversion ratio of 10:1 and is purchased for $900. After a few years, the common stock price rises to $120. What is the profit if the bond is converted and the common shares are sold?
Can you figure it out?
(spoiler)
Step 1: factor in bond purchase
Bond purchase=$900
Step 2: find conversion value
Conversion ratio=10
Conversion value=10 shares x $120
Conversion value=$1,200
Step 3: compare conversion value to the original purchase
Profit=conv. value - original purchase
Profit=$1,200 - $900
Profit=$300
As you can see, convertible bonds provide an added return potential. Because of this, this type of debt security is sold with lower interest rates and trades at lower yields (higher prices) in the market.
How does an investor know when to convert their bond? Parity pricing helps determine when conversion is profitable. The stock parity price describes the equivalent stock cost if a bond is bought and converted.
A corporate bond has a conversion ratio of 10:1 and is purchased for $900. What is the parity price of the common stock?
Stock PP=conversion ratiobond market price
Stock PP=10$900
Stock PP=$90
If a $900 bond is purchased and immediately converted into 10 shares of common stock, the investor is paying the equivalent of $90 per share for the stock. The investor could profit if the stock trades at any price above $90. In the example above, the stock’s market price was $120, which provided a $30 per share profit.
Bond parity price can also determine if conversion is profitable. This time, we’ll use the stock’s market price to determine if a convertible bond should be purchased and converted immediately.
A corporate bond has a conversion ratio of 10:1 and is purchased, while the common stock trades at $90. What is the parity price of the bond?
Bond PP=stock price x conversion ratio
Bond PP=$90 x 10
Bond PP=$900
If the bond trades in the market at any price below $900, then the bond should be purchased and converted immediately. This allows the investor to sell the stock for a higher value than the bond’s purchase price, providing an immediate profit.
Parity prices are not a heavily tested topic on the SIE, but you could encounter a question or two on the exam.
Mezzanine debt
You may have heard the term ‘mezzanine,’ which typically describes a stage between a floor and ceiling. This picture shows an example:
Mezzanine debt borrows its name from this structure. This type of security maintains a liquidation priority between senior-level debt (“the ceiling”) and equity/stock (“the floor”). In the event of a liquidation, holders are “paid out” after senior debt holders, but before stockholders.
Issuers of mezzanine debt are commonly smaller corporations and start-ups seeking non-traditional ways to raise capital (money). To entice investors to purchase these securities, issuers structure mezzanine debt offerings to provide significant yields. However, issuers are careful to burden themselves with substantial interest costs. Instead, mezzanine debt allows issuers to get creative with how to offer high rates of return by creating a type of ‘hybrid’ security.
Here’s an example of how a mezzanine debt offering may appear:
$1,000 par (principal/face)
10-year maturity
10% coupon
4% PIK interest
4 warrants to purchase issuer’s common stock
The first three lines above should seem familiar. Like all other forms of debt, this example of mezzanine debt maintains a fixed par value, maturity (most are long-term), and coupon. It’s the last two lines that are unique.
PIK stands for ‘payment-in-kind.’ Instead of paying interest semi-annually in cash, PIK interest adds the “payable interest” to the loan’s principal. To illustrate this, let’s assume PIK interest is “paid” annually to the mezzanine debt holder. After the first year, the security’s par value would increase to $1,040 ($1,000 x 4% PIK interest = $40 added to principal). Each subsequent year, the debt security’s principal rises by 4%. The investor “receives” this interest at maturity when the issuer must repay the loan’s face value. Don’t worry about the math for exam purposes, but the total principal paid at maturity in this example would be roughly $1,480.
In addition to the coupon and PIK interest, this mezzanine debt example also includes warrants. If you recall from a previous chapter, warrants allow an investor to purchase common stock from the issuer at a fixed exercise price. When the warrant is issued initially, the exercise price is typically set at a premium to the stock’s current market value. For example, a warrant may allow an investor to purchase an issuer’s stock for $50 when its current market value is $40. This element gives the investor additional return if the company’s stock performs well.
Mezzanine debt can be structured differently and doesn’t always resemble the above example. Some issues maintain varying coupons, offer conversion features instead of warrants, or exclude PIK interest (among many other variations). However, one thing is clear based on the name - this type of security sits between senior debt and equity on the priority scale if an issuer is forced to liquidate.
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