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Convertible Bonds 101

A convertible bond is a hybrid fixed-income security that can be converted into shares of the issuer's common stock at a predetermined price (known as the conversion price). The holder of a convertible bond does not have the option to redeem the security until the market value of the issuer's common stock is equal to or greater than the conversion price. The conversion ratio represents the number of shares of common stock that can be received upon the redemption of each convertible bond.

Why do companies issue convertible bonds? Suppose a company needs to raise capital but its stock price is currently low. The company can't risk issuing more stocks because (1) the company would have to issue a greater amount of stock to raise sufficient capital (due to the low stock valuation) and (2) the additional shares would dilute dividend earnings. The company may not want to issue debt because the cost of obtaining capital (market interest rates) may be too high. However, a company can issue convertible bonds at a lower yield than traditional coupon bonds and convert them to equity when their stock’s value appreciates.

Risk

The default risk of convertible bonds is greater than traditional bonds because convertible bonds are subordinated to outstanding coupon bonds in the event of liquidation. However, convertible bondholders are paid before stock investors. Interest rate risk is also significant. Because convertible bonds yield less than traditional coupon bonds, an increase in market interest rates will cause a greater decline in the price of convertibles than non-convertible bonds. In addition, coupon bonds are vulnerable to call risk. If market interest rates decline the bond is likely to be called because the issuer can reissue new bonds at a lower cost of capital.

Convertible Bond Valuation

Convertible bonds are interesting because their price adjusts to both market interest rates and the value of the issuer's stock. If the stock price is sufficiently greater than the specified conversion price, the convertible will be valued as common stock. A valuation based on stock is simply number of shares received per the conversion ratio multiplied by the market value of the stock. As the stock’s value rises, the price of the convertible bond rises. If the sock price falls far below its price at the convertible bonds' issue, the bond will be valued as debt.

Questions:

1. Describe the circumstance in which a company would benefit by issuing convertible debt.

2. Explain why convertible bonds have greater default risk relative to traditional bonds.

3. Describe the conditions in which a convertible bond will be valued as common stock.

4. Describe the conditions in which a convertible bond will be valued as debt.

Answers:

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