A1.6.1.1. Convertible Bonds
A convertible bond is a bond that can be exchanged or “converted” into some form of equity, typically the issuer’s common stock. Such bonds usually convert, if at all, at the option of the holder; much less common are mandatorily converting convertibles, which convert to common shares at maturity.
Convertible bonds can be appealing options for both issuers and investors. For the investor, a convertible bond combines the fixed returns of a bond with the upside potential of equity. Because of this potential upside, however, convertible bonds usually pay a lower coupon than nonconvertible bonds. Issuers tend to like this aspect of convertible bonds, because it results in lower borrowing costs. The delayed and dilutive effect of convertible bonds is also appealing to the many issuers who prefer to offer debt securities in the medium term while realizing that expected company financial growth will make future share dilution more palatable.
A convertible bond’s indenture or prospectus specifies the conversion date, if there is one—some convertible bonds may be converted at any time. The indenture usually includes some form of call protection, since convertibles would be much less attractive if the issuer could call the bonds. Finally, the indenture states the conversion ratio, the number of shares into which each bond can be converted.
The conversion ratio is specified in the indenture at the time of issue. The ratio can be expressed either as an actual ratio (X number of shares per bond) or as a conversion price. If expressed as a price, the ratio is determined by the following formula:
The higher the ratio, the more shares of stock the bon