Convertible Bonds – Can they be Converted to Common Shares? Also, an inspection of Bond Conversion Premiums
Most newbie investors are confused as to what convertible bonds are; they wonder are they really bonds or convertible bonds that are stocks, or both? Basically, convertible bonds are corporate bonds (bonds issue by large organizations) that are convertible in to the common stock of that issuing corporation. Convertible bonds are when bondholders can exchange their bonds for a fixed number of the issuing company’s common shares. Convertible bonds allow bondholders the potential to increase their net worth by future increases in the market value of the common shares of the issuing company. If the share prices of the company do not increase and the bonds are not converted, bondholders will continue to receive periodic interest payments and their principal amounts upon maturity.
Bond Conversion Ratio
The bond conversion ratio is also known as the conversion premium and ultimately determines how many shares can be converted from each bond outstanding. This conversion can be expressed as a ratio or as the conversion price. Usually the details regarding this are stated in the bond’s agreement or indenture.
As an example, consider Jahmani Corp. offers bonds with a conversion ratio of 32:1 for their bonds with a $1000 par value. This means each bond outstanding (with a par value of $1,000) can be exchanged for 32 shares of the issuing company’s common shares.
Let’s consider a hypothetical bond conversion example to clarify the conversion process & accounting rules. Assume that Jahmani Corp. is issuing a new bond to the market with a 6% coupon rate and 10 years to maturity. The company has other 10 year term debt that carries an 8% yield and the company’s stock price is currently trading at $41. Here is a summary of this data in tabular format
From this example, we know that the bond has a face or par value of $1,000. Therefore if we were to convert the bond at its par value to shares at the conversion price, we would end up with the following # of shares:
This simply means that if we were to convert 1 of our bonds outstanding to the company’s stocks at the conversion price of $50/share, we would end up getting 20 shares of common stock of Jahmani Corp.
However, notice that the current stock price is lesser than the conversion price of $50/share; it is at $41/share. So how do we know the current value of our convertible bond? We can know this by multiplying the # of shares multiplied by current stock price.
If the bond is converted at par value, then the conversion premium is calculated as:
Conversion Premium = The amount by which
the price of a convertible security exceeds the current market value of
the common stock to which it may be converted. Our answer in this scenario
To express the conversion premium in a percentage format, we divide the conversion premium by the current bond value. An example is laid out below:
This simply means that if the investors want to convert
their current bonds in to the common stock of their issuing company’s
shares, they will have to pay a 19% conversion premium in order to obtain
the stocks at 100% of its fair value.