A convertible bond is a bond that can be converted into shares of common stock. Therefore, these are two sources of value for this security: the value of the bond components, and the value from possibly converting the security into shares of common stock. Features of a Convertible Bond The basic features of a convertible bond can be illustrated by a hypothetical example. On November 1, 2003 ("today"), Apple, had $400 million in 8.80 percent (annual payments) convertible bonds due in 2013. The bonds are convertible into the common stock of Apple anytime before the maturity at a conversion price of $50.00 per share. Because each bond had a face value of $1,000, the holder of a Apple convertible bond could exchange that bond for $1,000/50 = 20 shares of Apple common stock. The number of shares received for each bond, 20 in this example, is called the conversion ratio. The conversion ratio is found by dividing par value by the conversion price. Of course, the conversion price (and conversion ratio) must be established when the bond is issued. When Apple issued its convertible bonds, its common stock was trading at $32.625 per share. The conversion price of $50 was thus (50 - 32.625)/32.625 = 53.26% higher than the actual common stock price. This 53.26% is called the conversion premium. Now that the bond trades in the secondary market, a similar calculation can be made if the existing stock price is below the conversion price. Value of a Convertible Bond A convertible has two possible sources of value: the straight bond value and the conversion value. At any moment, both values must be determined in order to see which dominates, i.e. which is the driving force in the current value of the convertible. straight bond value The straight bond value is what the convertible bond would sell for if it could not be converted into common stock. This is determined in exactly the same was as a standard bond—by observing the relevant market interest rate (opportunity cost of investment) and calculating the present value. Suppose today the relevant market interest rate (incorporating maturity and default risk) of straight bonds issued by Apple is 7.25%. The straight bond value today is $1,107.62. The straight bond value will always be changing, as the present value of the bond payments will change when the market interest rate (the relevant discount rate) changes. The straight bond value of a convertible bond is the minimum value of the security as the convertible is always worth at least this amount. As is discussed below, it will usually be worth more than this amount.
conversion value The conversion value of a convertible bond is what the bond would be worth if it were immediately converted into common stock. This value is computed by multiplying the current price of the stock by the number of shares that will be received when the bond is converted. For example, suppose that on November 1, 2003 Apple common was selling for $51.10. The current conversion value is 20 x $51.10 = $1,022. Now that the two possible sources of value have been quantified, it can be seen that at this point of time the straight bond value is greater than the conversion value. Therefore, today the convertible derives its value from the straight bond value. However, if tomorrow the stock price goes to $56 and the market interest rate remains the same, the conversion value would be $1,120. Now, the conversion value is greater than the straight bond value and convertible would derive its value from the conversion value. As shown below, the minimum, or floor value of a convertible bond is either its straight bond value or its conversion value, depending on which is greater.
Figure 1: Convertible Bond Floor Values
convertible bond value ($) conversion value = shares(PS)
convertible bond floor value
straight bond value = Conversion ratio straight bond value (SBV) greater than conversion value straight bond value less than conversion...
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