Convertible Bonds

With your understanding of bond types in place, you're ready to tackle convertible bonds, a hybrid security that combines features of both debt and equity. This is one of the most calculation-heavy topics in the corporate bonds unit.

General Characteristics

A convertible bond gives the bondholder the right to convert the bond into a fixed number of shares of the issuer's common stock.

Key features:

• Conversion is at the bondholder's option (not the issuer's)
• Convertible bonds pay a lower coupon rate than comparable non-convertible bonds because the conversion feature has value
• Once converted, the bondholder gives up the bond (and future interest payments) in exchange for stock
• The conversion feature is an advantage to the investor; they get to choose if and when to convert

Exam Tip: Gotchas

• Conversion is the bondholder's choice, NOT the issuer's. The exam may phrase this as "at the option of the holder."
• Convertible bonds pay LOWER coupons than comparable non-convertible bonds (not higher) because the conversion privilege has value.

Conversion Ratio and Conversion Price

The two key terms are inversely related:

• The conversion ratio is fixed at issuance and does not change
• Exception: adjusted for stock splits or stock dividends to prevent dilution
• Higher conversion price = lower conversion ratio (inverse relationship)

Exam Tip: Gotchas

• The conversion ratio is fixed at issuance and only adjusted for stock splits or stock dividends. Market price changes do NOT affect it.

Parity Price Calculations

The parity price is the price at which the bond and the stock have equal value upon conversion. This is a frequently tested calculation.

Worked example (Bond at $1,100, conversion ratio = 20):

• Stock parity = $1,100 / 20 = $55 per share
• If stock trades at $55, the bond and stock are at parity

Think of it this way: Parity is the break-even point. If converting the bond gives you stock worth exactly the same as the bond's market price, there is no advantage either way. Above parity, conversion is profitable; below parity, you are better off holding the bond.

Arbitrage

When the conversion value exceeds the bond's market price, an arbitrage opportunity exists:

1. Buy the underpriced bond
2. Convert to stock
3. Sell the stock at market price for a profit

Arbitrage activity quickly eliminates pricing discrepancies and brings the bond back to parity.

Factors Influencing Conversion

How a convertible bond trades depends on where the stock price is relative to the conversion price:

• The bond will never trade below its investment value (the value it would have as a straight bond without the conversion feature); this creates a price floor

Exam Tip: Gotchas

• The investment value (straight bond value) acts as a price floor. Even if the stock price drops to zero, the convertible bond still has value as a bond paying interest.

Forced Conversion

Forced conversion is an economic mechanism, not a direct mandate:

1. The issuer calls the bond at the call price (e.g., $1,050)
2. If the conversion value exceeds the call price (e.g., stock at $60 x 20 shares = $1,200), the bondholder is economically compelled to convert
3. A rational investor takes $1,200 in stock rather than accepting $1,050 in cash

Exam Tip: Gotchas

• "Forced conversion" does NOT mean the issuer directly forces conversion. The issuer calls the bond at, say, $1,050. If conversion value is $1,200, a rational bondholder converts rather than accepting $1,050. The exam tests whether you understand this economic incentive mechanism.

Fixed vs. Variable Conversion