Convertible bond

A convertible bond is a debt obligation of the issuer to which the terms of issue attach the holder's right to exchange the paper for a set number of shares of the same issuer. Until the exchange, it is ordinary debt: it has a face value, a maturity date, a coupon schedule and a place in the queue of creditors in a bankruptcy. Once the exchange is made, the debt disappears, and the former creditor becomes a shareholder, giving up both the coupon and the right to have the face value repaid.

How conversion works

The terms of issue set two things: the conversion ratio, meaning how many shares each bond is worth, and the windows in which the right can be exercised. The conversion ratio gives the conversion price: the face value divided by the number of shares. While the share trades below that price, converting yields less than simply holding to redemption, and the paper behaves like a bond with a reduced coupon. Once the share moves above it, the value of the block of shares starts pulling the bond's price up, and the bond decouples from its debt floor.

Issuers often add their own right to redeem the paper early. This works the same way as an issuer call option, and it can cut the option's life short at precisely the moment it becomes most valuable to the holder. Credit risk is assessed separately: the debt component of a convertible protects the price on the downside only to the extent that the issuer is able to pay at all.

What to look at in an example

The main input for valuation is not the bond screen but the price of the underlying share and the range of its swings: the higher the volatility, the more valuable the embedded conversion right. The conversion price from the prospectus is compared with the share's current quote:

If the share is far below the conversion price, the option has almost no effect on the bond's price, and the paper is read through its yield to maturity. If the share is above it, yield to maturity no longer describes the expected outcome, because the issue will most likely not survive to maturity.

What it is confused with

A convertible bond is regularly mixed up with a substitute bond, which involves no exchange for shares at all and only changes the payment arrangements on existing debt. The second common mistake is treating the conversion right as a guarantee of sharing in the upside: conversion windows are limited, and if the issue is called or the capital is diluted by a new share issue, the ratio is recalculated using the formula in the prospectus, so the holder's actual stake turns out to differ from the one they had in mind when they bought.