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:
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 its conversion ratio and conversion price. These determine how many shares of stock you receive if you convert the bond. Both generally stay fixed for 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 mainly useful because it lets you calculate the conversion ratio.
A convertible bond has a conversion price of $40. What is the conversion ratio?
So the conversion ratio is 25:1, meaning one bond can be converted into 25 shares of common stock. The conversion ratio is the key input for most convertible bond math questions. If the question gives you the conversion price, use the formula above to find the ratio.
If the question provides the conversion ratio, you already know how many shares you’ll receive upon conversion. Sometimes, though, you’ll be given the conversion ratio and asked for the conversion price.
A convertible bond has a conversion ratio of 20:1. What is the conversion price?
This is the same relationship as the conversion ratio formula - just rearranged.
Now let’s 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 conversion if the common stock price rises above $90. Conceptually, they’re buying a “10-pack” of shares for $900. On a per-share basis:
If the market price of the common stock rises above $90, converting creates a profit opportunity.
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?
Step 1: factor in bond purchase
Step 2: find conversion value
Step 3: compare conversion value to the original purchase
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.
How does an investor decide when conversion makes sense? Parity pricing helps you compare the bond and the stock.
The stock parity price describes the equivalent stock cost per share if you buy the bond and convert it.
A corporate bond has a conversion ratio of 10:1 and is purchased for $900. What is the parity price of the common stock?
If a $900 bond is purchased and immediately converted into 10 shares, the investor is effectively paying $90 per share. The investor could profit if the stock trades above $90. In the earlier example, the stock traded at $120, which is a $30 per share difference.
You can also use the bond parity price to decide whether it’s attractive to buy a convertible bond and convert immediately. Here, you start with the stock’s market price and convert it into an equivalent bond value.
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?
If the bond trades in the market below $900, an investor could buy the bond and convert immediately, then sell the stock for more than the bond’s purchase price (creating an immediate profit).
Parity prices aren’t heavily tested on the SIE, but you may see a question or two.
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.
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