2.4.12.4. Convertible Bonds
Convertible bonds are bonds that can be converted into shares of common stock (and sometimes preferred stock) at a fixed conversion ratio, which is stipulated in the bond indenture.
The conversion price is usually set at a premium to the market price of the common stock at the time that the bonds are issued. For example, if the common stock is trading at $20 per share, the convertible bonds may be issued at a conversion price of 25% above the market price. This would be $20 × 1.25 = $25 per share. To get the conversion ratio, which is the number of shares of stock an investor receives for one bond, the bondholder can divide the conversion price into the par value of the bond. In this case, $25 into the $1,000 par value = 40 shares per bond.
Example Question
A customer purchased a 6% XYZ convertible debenture at par for $1,000. The conversion price is $20. If the bond’s market price increases by 10%, what is the conversion ratio?
Answer: 50. Find the conversion ratio by dividing the conversion price into the par value: $1,000 / $20 = 50 shares of common stock for 1 bond. The conversion ratio is not influenced by a rise in the market price of the bond.
The decision to convert a bond will depend on its conversion value and the current market value of the bond. The conversion value, which is the bond’s value if it were to be converted at the present moment, is the conversion ratio times the current market price of the stock. A convertible bond’s conversion parity or parity price is the price at which the bond needs to be trading for the conversion ratio times the market price of the common stock to be equal to the bond’s market price.
Example: A convertible bond has a conversion ratio of 50 and the issuer’s stock is currently selling at $24. The bond’s conversion value is $1,200 (50 shares × $24/share). If the bond is selling at $1,200, it is said to be at conversion