The first is to lower the coupon rate on debt. Investors will generally accept a lower coupon rate on a convertible bond, compared with the coupon rate on an otherwise identical regular bond, because of its conversion feature. This enables the issuer to save on interest expenses, which can be substantial in the case of a large bond issue.
The second reason is to delay dilution. Raising capital through issuing convertible bonds rather than equity allows the issuer to delay dilution to its equity holders. A company may be in a situation wherein it prefers to issue a debt security in the medium-term—partly since interest expense is tax-deductible—but is comfortable with dilution over the longer term because it expects its net income and share price to grow substantially over this time frame. In this case, it can force conversion at the higher share price, assuming the stock has indeed risen past that level.
The conversion ratio—also called the conversion premium—determines how many shares can be converted from each bond. This can be expressed as a ratio or as the conversion price and is specified in the indenture along with other provisions. The chart below shows the performance of a convertible bond as the stock price rises. Notice the price of the bond begins to rise as the stock price approaches the conversion price. At this point, your convertible performs similarly to a stock option.
As the stock price moves up or becomes extremely volatile, so does your bond. It is important to remember that convertible bonds closely follow the underlying share price. The exception occurs when the share price goes down substantially. In this case, at the time of the bond's maturity, bondholders would receive no less than the par value.
One downside of convertible bonds is that the issuing company has the right to call the bonds. In other words, the company has the right to forcibly convert them. Forced conversion usually occurs when the price of the stock is higher than the amount it would be if the bond were redeemed. Alternatively, it may also occur at the bond's call date. A reversible convertible bond allows the company to convert it to shares or keep it as a fixed income investment until maturity.
This attribute caps the capital appreciation potential of a convertible bond. The sky is not the limit with convertibles as it is with common stock. The notes were in two tranches, a five-year due in with a 0. The conversion rate is The certainly had the potential to double as it was a volatile social media stock and, given a low-interest rate environment, the principal protection isn't worth as much as it might otherwise be.
Convertible bonds are rather complex securities for a few reasons. First, they have the characteristics of both bonds and stocks, confusing investors right off the bat.
Then you have to weigh in the factors affecting their price. These factors are a mixture of what is happening in the interest-rate climate, which affects bond pricing, and the market for the underlying stock, which affects the price of the stock.
Then there's the fact that these bonds can be called by the issuer at a certain price that insulates the issuer from any dramatic spike in the share price. All of these factors are important when pricing convertibles. However, there is usually a cap on the amount the stock can appreciate through the issuer's callable provision. This means while convertible bonds limit the risk if the stock price plummets, they also limit exposure to upside price movement if the common stock soars.
The bond can be converted at any point up until maturity. Like standard nonconvertible bonds, issue a convertible bond with a set par value , maturity date , and coupon rate. Convertibles are attractive instruments to investors because they combine the reliability of a debt instrument with the potential upside profits of shares of stock. The downside, however, is that a convertible bond will offer the investor a lower yield than a nonconvertible bond.
This is because of the potential benefits of conversion feature. Convertible bonds are also typically callable, which means the issuing company can force the investor to convert the bond for a specified number of shares of stock at a certain price. Issuing a convertible bond is an attractive financing option for a company because it is cheaper than issuing a nonconvertible bond.
The benefits of the conversion feature allow the issuing company to pay a lower coupon rate to the bondholder. As a result, the investment value is determined by the usual criteria for valuing corporate bonds - the shape of the current government bond yield curve, and the appropriate credit spread.
As the chart on page 6 shows, the investment value is independent of the share price provided the company is not in distress. If the share price is collapsing, that would be reflected in a deterioration in its creditworthiness and hence an increase in the spread of all its bonds - including convertibles.
The investment value will in general be below the par value of the convertible as the coupon would generally be lower than the coupon of a straight bond, which would be priced at par. The higher the premium, the more sensitive the market price of the convertible is to a decline in the price of the shares, and less downside protection is provided: there would have to be a larger fall in the share price before the convertible starts approaching its investment value, which would provide the downside protection if the company is not distressed.
At the time of issue of a convertible, the offering prospectus indicates the share price equivalent to the value of the bond at par.
Clearly, once the convertible bond has been issued, its price will trade above or below par value, but it will always be exchangeable for the same number of shares, known as the conversion ratio.
The conversion value represents the equity value of a convertible and is what the convertible would be worth if was converted into shares at current market prices. In the chart, the conversion value is the diagonal line as it is directly proportional to the share price.
The conversion premium is simply the difference between the current market price of the convertible and the conversion value expressed as a percentage of the market value.
As the convertible bond is more secure than equity and generally has a higher yield than the stock dividends, the convertible holder is willing to pay a premium over the conversion value. As the share price gets higher, the value of the convertible converges with the value of the equity, reducing the conversion premium. Unsurprisingly, much of the demand for convertible bonds has historically been generated by hedge funds.
Hedge funds can arbitrage the value of the convertible with the value of its component elements in different ways depending on where the fair value of the convertible is, relative to stock and bond valuations.
The huge losses recently in convertible arbitrage funds occurred because of the failure of key elements of the arbitrage strategy and, in particular, the drying up of the debt markets and the ban on short sales of financial stocks that accounted for a large part of the convertibles strategy.
When the fair value is in the region that the convertible bond exhibits equity characteristics, it can be viewed as a deep-in-the-money option. Hedge funds would sell the stock and buy the convertible with no net exposure to the share price.
The return would be the coupon plus the interest earned from the short stock position, minus the cost of borrowing the stock and the cost of dividends foregone from not owning the stock.
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