Types of Convertible Bonds

A convertible bond, also called a convertible note, is similar to a regular corporate bond with one exception: It can be exchanged for shares of stock. When you own a convertible bond, you receive interest payments as well as repayment of the bond’s face value at maturity. In addition, you can convert the bond to a specified number of underlying stock shares. The price of convertible debt stems from its value as a bond and its value if converted to stock.

Characteristics of Convertible Bonds

The main characteristics of a convertible bond are:

• Price: The amount you must pay to obtain the bond or the proceeds you’ll collect from selling the bond
  
• Maturity date: The date when the bond expires and is redeemed by the issuer for its face value
  
• Face value: The principal amount you receive when the bond matures
  
• Interest rate: The annual amount of interest you receive as a percentage of the bond’s face value
  
• Underlying stock: The stock shares you’ll receive if you convert the bond
  
• Conversion terms: The circumstances under which you can convert the bond
  
• Conversion ratio: The number of shares you’ll receive from converting the bond
  
• Conversion price: The price you paid for a convertible bond divided by the conversion ratio
  
• Conversion value: The conversion ratio times the current stock price
  
• Conversion premium: Equal to (conversion price x conversion ratio) - conversion value
  

There are several types of convertible bonds more complex than the traditional variety, but all share these characteristics.

Example of Conversion Price Calculation

Suppose you own an XYZ Corp $1,000-face convertible bond that you purchased at issuance for $1,060. The bond converts into 10 shares of XYZ common stock, giving a conversion price of $106 per share (i.e., $1,060/10). In other words, the stock price would have to rise above the breakeven price of $106 per share for you to profit from conversion. Typically, the conversion price on newly issued convertible bonds is well above the current stock price.

Calculating Conversion Premium

If shares of XYZ stock are currently selling for $90, the conversion value of the XYZ bond is 10 shares/bond x $90/share or $900. The conversion premium in this case is:

(($106 conversion price x conversion ratio of 10) - conversion value of $900) = (1,060 - $900) = $160

So, $160 is the amount you would lose if you converted the bond at the current price.

Interpreting Conversion Premium

If you put the conversion premium on a percentage basis, you can compare it with those of similar bonds. Do this by dividing the premium by the conversion value. In the example, this is $160 divided by $900, or about 18 percent. This is the percentage you “overpay” to obtain the conversion option.

Another way of interpreting the conversion premium percentage is the amount the stock price has to rise before reaching the breakeven point between the bond value and the conversion value. In this example, the breakeven price, or parity, is $106 per share. As the stock price rises above parity – a negative premium – it pulls the convertible bond price higher, and you would therefore make the same profit by selling the bond as you would by converting it and immediately selling the underlying shares.

For example, if the price of XYZ shares rises to $110, the bond price would equal 10 x $110, or $1,110. You would collect this amount if you simply sold the bond. Equivalently, you could convert the bond into 10 shares of XYZ stock and sell them for $1,110. In either case, your profit is $1,110 - $1,060, or $50, ignoring commissions.

Callable Convertible Bonds

Many convertible bonds have call risk – the issuer can forcibly redeem the bond before maturity at a preset price, the call price. Issuers often set the call price just above the conversion price. Issuers then call convertible bonds when the conversion value reaches the call price, thereby forcing bondholders to convert their bond into shares. By doing so, the issuer removes the remaining time value of the conversion option for the period from the call date until the maturity date.

For example, if XYZ Corp assigns a call price of $1,070 to its convertible bond, it would call the bond when XYZ stock price reaches $107. You would collect a $10 profit (i.e. 10 x $107 - $106), but you will forego any additional profit should the XYZ stock price continue to rise. Callable convertible bonds are therefore less desirable than non-callable ones, and accordingly sell for a little less than a non-callable version would.

Time Value of Callable Convertible

The value from the ability to convert a bond to shares can be thought of as a combination of the bond’s value as a non-convertible, or straight, bond, and the value of the conversion option. Normally, the conversion option expires when the bond matures – the convertible option has time-value until maturity. By attaching a call option to the convertible bond, the issuer reduces the time value of the conversion option, since the bond can be redeemed before maturity.

The time value is valuable to bondholders but is a negative for stockholders – the longer the bonds can benefit from a rising stock price, the larger the potential discount below market price bondholders will receive on converted shares. The discount between market and conversion price is an opportunity cost – the issuer could sell new stock for the market price, which is higher than the conversion price. Since management’s job is to maximize the wealth of stockholders, the issuer will call the bonds and transfer the time value to the stockholders.

Puttable Convertible Bonds

A puttable convertible bond gives bondholders the right, but not the obligation, to force the issuer to repurchase the bond at specified prices on specified dates. In effect, the put option attached to the convertible bond creates a floor underneath the bond’s price. The put option is valuable to the bondholder and therefore allows the issuer to demand a higher issuance price.

Mandatory Convertible Bonds

These bonds must be converted by the issuer-specified conversion date. These bonds typically have short maturities. The only way for bondholders to avoid conversion is to sell the bond before the mandatory conversion date.

Convertible to Preferred

Convertible to preferred bonds convert into shares of preferred stock rather than common. Preferred stock is a hybrid between common stock and a bond, in that the principal is not guaranteed but the dividend rate is high.

Exchangeable Bonds

When a bond can be converted to the shares of another company, it is known as an exchangeable bond. These are sometimes exchangeable to a blue-chip underlying stock to boost the demand for the bond.

Contingent Convertible Bonds

Contingent convertibles, or CoCos, can be converted only if the bond price exceeds the conversion price by some fixed percentage. The underlying stock price must exceed the required price for a given amount of time before conversions are permitted. CoCos are usually issued by banks to bolster their capital structure.

Foreign Currency Convertible Bond

In a foreign currency convertible bond, the bond is issued in a currency different from the issuer’s domestic currency. In other words, the issuer can use this bond to raise money in a foreign currency that might be stronger than the issuer’s domestic currency.