Convertible products
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 Motor Co. bond would allow the bondholder to convert the bond into Ford stock.
A conversion feature gives investors an additional way to earn a return:
- The bond’s yield provides income.
- If the investor converts to stock, they may also earn capital gains (buy low, sell high) if the stock price rises.
As discussed in the common stock unit, issuing convertible securities is a dilutive action for common stockholders. Because of that, the issuer must obtain shareholder approval to issue convertible bonds.
When a convertible bond is issued, the issuer sets the bond’s conversion price, which determines its conversion ratio. Both generally stay 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?
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?
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.
Every other convertible bond calculation compares two amounts:
- What the bond costs in the market
- What the shares it converts into are worth, called the conversion value (conversion ratio x the stock’s market price)
When the two amounts are equal, the bond and the stock are at parity. Let’s follow one bond through each calculation.
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 stock parity price:
The stock parity price 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?
Step 1: find the conversion value (what the 10 shares are worth now)
Step 2: compare the conversion value to what the investor paid for the bond
The stock parity price gives the same answer. Each share effectively cost $90 and sells for $120, a $30 gain per share. Across 10 shares, that’s $300.
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 return potential. Because of that, they’re typically issued with lower interest rates and trade at lower yields (higher prices) than comparable non-convertible bonds.
Question 3: Is the bond priced fairly compared to the stock?
Parity also works in the other direction. Instead of starting with the bond’s price and finding a break-even stock price, start with the stock’s price and ask what the bond is worth based on conversion alone. That’s the bond parity price, and it’s the same calculation as the conversion value.
The same 10:1 bond is available in the market while the common stock trades at $90. What is the parity price of the bond?
With the stock at $90, the 10 shares are worth $900, so the bond is worth $900 on conversion alone. This is Question 1 seen from the other side: a $900 bond and a $90 stock are at parity.
If the bond traded below its parity price (say, $850 while the stock is at $90), an investor could buy the bond, convert it immediately, and sell the 10 shares for $900, locking in a $50 profit. Buying and selling at the same time to profit from a price difference like this is called arbitrage.
Both parity prices come from the same relationship. At parity:
- To find the stock parity price, divide the bond price by the conversion ratio.
- To find the bond parity price, multiply the stock price by the conversion ratio.
Parity prices aren’t heavily tested on the SIE, but you may see a question or two.
Mezzanine debt
You may have heard the term “mezzanine,” which typically describes a level between a floor and a ceiling. This picture shows an example:
Mezzanine debt borrows its name from this structure. It has a liquidation priority between senior-level debt (the “ceiling”) and equity/stock (the “floor”). In a liquidation, holders are paid 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 attract investors, issuers often structure mezzanine debt to offer high total return potential. At the same time, they may try to limit immediate cash interest costs. This is why mezzanine debt is often designed as 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 should look familiar. Like other forms of debt, this mezzanine issue has a fixed par value, a maturity date (often long-term), and a coupon rate. The last two lines are the features that make it “mezzanine.”
PIK stands for payment-in-kind. Instead of paying that portion of interest in cash, PIK interest is added to the loan’s principal.
To illustrate, assume the PIK interest is added annually. 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 principal increases by 4%. The investor receives this accumulated amount at maturity, when the issuer repays the face value. You don’t need to do this math for the exam, but the total principal paid at maturity in this example would be roughly $1,480.
In addition to the coupon and PIK interest, this example includes warrants. As covered in a previous chapter, warrants allow an investor to purchase common stock from the issuer at a fixed exercise price. When a warrant is issued, 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 stock for $50 when the current market value is $40. If the stock performs well, that feature can add to the investor’s total return.
Mezzanine debt can be structured in many ways and won’t always match the example above. Some issues have varying coupons, offer conversion features instead of warrants, or exclude PIK interest (among other variations). The defining idea is the same: mezzanine debt sits between senior debt and equity in liquidation priority.