Convertible bonds

Convertible bond is a fixed income security that can be converted to the company’s equity shares at any point in time of the tenure and is exercised by the bond holder. To be more specific the bond is converted to common shares that are traded in the secondary market.

Conversion from bond to shares when the investor anticipates huge upside for the stock. Generally the bonds trade together with the stock price no much difference can be seen until the fixed income characteristic subdues. These bonds either trade with a lower coupon rate or at a premium as the investor can gain profit from the conversion. The owner has the upper hand in case if a convertible bond same as the puttable bond.

Conversion Price- The price per share at which the bond is converted.

Conversion ratio- The number of shares the bond holder gets when the conversion happens.

Conversion Value- Market value of shares that would be received upon conversion.

All the parameters are set at the time of issue and is mentioned in the bond indenture. The difference between the conversion price and current traded price is the return from exercising the conversion. The disadvantage of issuing a convertible bond is, conversion dilutes the equity ownership by increasing the equity base. The company has to buy back at a lower price in order to reduce the equity base.

Companies issue convertible bonds to reduce financing rate as investors accept lower rates for a convertible bond and are tax deductible. The share price is affected as the volume traded increases, so does the volatility of the stock. Tax treatment for convertible bonds is same as ordinary bonds.

Convertible bonds and warrants are different instruments, warrants are issued by young firms to finance projects, with high yield and shares profits which compensates for the risk of defaulting. Callable bonds gives right to the issuer, thus adding to the call risk which is compensated by higher yield.

When will a convertible bond be called?

Mostly with a call option, so the issuer can call and force the bondholder to convert. This happens when the dividend yield (rise in share price) is less than the bond yield. A convertible bond is called when the cap price is attained and the bond is mandatory to be called at the price. Cap is the upper limit under which the bondholder has the right to convert to shares. This puts the issuer to a safer premise. Convertible bond is kind of an arbitrage, where the bond holder is rewarded in the future with a lower price of shares that is valued more.

Example of convertible bond:

A bond with face value $100,000, coupon rate of 5% and 20% premium. The conversion price is at $30 per share.

  • 30 x 1.2= $36 per share.
  • If the share is trading at $40, $4 is the profit on conversion.
  • If the cap price is $50, the bond is called and is converted into shares at the aforementioned price, $36.