Investments and Convertible Bonds

A Convertible Bond (or convertible debenture) is a type of bond that can be converted into shares of stock in the issuing company, usually at some pre-announced ratio. It is a hybrid security with debt - and equity - like features.

Although it typically has a low coupon rate, the holder is compensated with the ability to convert the bond to common stock, usually at a substantial premium to the stock's market value.

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From the issuer's perspective, the key benefit of raising money by selling convertible bonds is a reduced cash interest payment.

However, in exchange for the benefit of reduced interest payments, the value of shareholder's equity is reduced due to the stock dilution expected when bondholders convert their bonds into new shares.

Like any typical bond, Convertible Bonds have an issue size, issue date, maturity date, maturity value, face value and coupon.

They also have the following additional features:

  1. Conversion Price:
    The nominal price per share at which conversion takes place.
  2. Conversion Ratio:
    The number of shares each convertible bond converts into. It may be expressed per bond or on a per centum (per 100) basis.
  3. Parity (Conversion) Value:
    Equity price × Conversion ratio.
  4. Conversion Premium:
    Represents the divergence of the market value of the Convertible Bond compared to that of the parity value.
  5. Call Features:
    The ability of the issuer (on some bonds) to call a bond early for redemption, sometimes subject to certain share price performance.

The intention is to encourage investors to convert early into equity (which has now become worth more than the bond's face value), by threatening repayment in cash for what is now a lower amount.

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Valuation

In theory, the market price of a Convertible Bond should never drop below its intrinsic value. The intrinsic value is simply the number of shares being converted at par value times the current market price of common shares.

The 3 main stages of a Convertible Bondʼs behavior are:

  1. In-the-Money Convertible Bonds:
    Conversion Price Is < Equity Price
  2. At-the-Money Convertible Bonds:
    Conversion Price Is = Equity Price
  3. Out-the-Money:
    Conversion Price Is > Equity Price.

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Uses for Investors

Convertible Bonds are usually issued offering a higher yield than obtainable on the shares into which the bonds convert.

Convertible Bonds are safer than preferred or common shares for the investor.

They provide asset protection, because the value of the Convertible Bond will only fall to the value of the bond floor.

At the same time, Convertible Bonds can provide the possibility of high equity-like returns.

Also, Convertible Bonds are usually less volatile than regular shares.

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The simultaneous purchase of Convertible Bonds and the short sale of the same issuer's common stock is a hedge fund strategy known as convertible arbitrage.

The motivation for such a strategy is that the equity option embedded in a convertible bond is a source of cheap volatility, which can be exploited by convertible arbitrageurs.

In limited circumstances, certain convertible bonds can be sold short, thus depressing the market value for a stock, and allowing the debt-holder to claim more stock with which to sell short. This is known as death spiral financing.

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