These are bonds which carry a rate of interest (like any other bonds) and give the owners the right (but not the obligation) to exchange the bonds at some stage in the future into ordinary shares according to a prearranged formula. Usually the conversion price is 10-30 percent greater than the existing share price. So if a $1 bond offered the right to convert to 40 ordinary shares. the conversion price would be $2.50 which, given the market price of shares of, say, $2.20, would be a conversion premium of (2.50-2.20)/2.20 = 0.136 or 13.6%
Advantages of convertible bonds to the company
a. Lower interest rate than on a similar bond. The firm can ask investors to accept a lower interest rate on convertibles because the investor values the conversion right.
b. The interest is tax deductible – because convertible bonds are a form of debt the interest payment can be regarded as a cost to the business and can therefore be used to reduce taxable profit.
c. Self-liquidating. When the share price reaches a level at which conversion is worthwhile the bonds will (normally) be exchanged for shares so the company does not have to find cash to pay off the loan principal- it simply issues more shares. This has obvious cash flow benefits. However, the disadvantage is that the other equity holders may experience a reduction in EPS.
d. Fewer restrictive covenants. The directors have greater operating and financial flexibility than they would with a secured bond. Investors accept that a convertible is a hybrid between debt and equity finance and do not tend to ask for high-level security, impose strong operating restrictions on managerial action or insist on strict financial boundaries.
e. Underpriced shares. A company which wishes to raise equity finance over medium term but judges that the stock market is temporarily underpricing its shares may turn to convertible bonds (if we do not believe in the efficient market hypothesis). If the firm does perform as the managers expect and the share price rises, the convertible will be exchanged for equity.
Advantages to the investors
a. They are able to wait and see how the share price moves before investing in equity.
b. In the near term, there is greater security for their principal compared with equity investment, and the annual coupon (interest) is usually higher than the dividend yield.
Conversion Price and Conversion Ratio
Conversion Price (CP): This is the nominal (face) value of the convertible bond that can be convened into one ordinary share. It represents the effective price paid for the ordinary shares if conversion occurs.
Conversion Ratio (CR): This gives the number of ordinary shares into which a convertible bond may be converted.
In most cases, it is expected that the share price will increase between the date of issue of the stock and the date of conversion in such a way as to mean that conversion on the due date will allow the bond holder to obtain shares at a discount to the prevailing market price.
The company’s dividend policy has a major impact on its share price, and hence on the perceived value of the convertible bonds. Assuming for the moment that the company is reasonably profitable, any profits which are not declared are ploughed back into the business; more profits should ensue and, other things being equal, the share price will rise. Whereas, by definition, dividends and retentions benefit the shareholders, only retentions benefit the convertible bond holders.
Companies usually issue convertibles with the expectation that the holders will exercise their options. Convertibles can therefore be seen as a form of delayed equity. They are attractive to the firm when the price of the ordinary shares is abnormally low at the date of issue, and at times when to issue a further tranche of equity would result in a significant drop in earnings per share. However, they also carry the risk that the share price will not rise in line with expectations at the time of issue and that holders will not therefore convert. If the bonds are dated, then the company must have funds in place to allow redemption on the due date. Convertibles also have a short-term benefit in that interest payments are allowable against tax.
Convertible therefore may form part of the strategy of a company whose objective is to raise new equity, but which for various reasons does not wish to go directly to the market in the short term. They are often preferable to straight loan stock since they do not commit the company indefinitely to the payment of large interest bills. They further allow the company to widen the investment base by attracting investors looking for a guaranteed short-term income plus the possibility of a capital gain at a later date. They have also recently formed a part of the strategy of companies that wish to manipulate their reported gearing and earnings per share, since they could choose whether to show them as equity or debt.
Valuation of convertible bonds
The debt and equity characteristics of convertibles produce two methods of valuation
a. Straight debt value: This is the value of the security, ignoring the option to convert. It is the present value of the interest payments and the redemption value discounted at the required return on an ordinary bond of the same risk.
b. Conversion value: This is the value of the ordinary shares into which the security could be converted.
The minimum value (otherwise called formula value) of a convertible is its value as straight debt or its conversion value, whichever is the higher. The actual value of a convertible bond will be greater than the formula value because of the value of the option to convert. On the last day for conversion however, the actual value will equal the formula value. Holders will either convert if the conversion value exceeds the straight debt value, or let the option lapse and keep the security as straight debt if this has a higher value.