Concept of Convertibles

➦ Convertible is one the feature of carried out by bonds, debenture and preferred stock which gives the option to the bondholders or stockholders to convert the shares into common stock.

➦ Convertible securities are the bonds, debentures and preferred stocks having convertible features are converted into common stock under pre-specified terms and conditions which is clearly mentioned at the time of issuance of these securities.

➦ Convertible securities receive fixed return on and additionally get option of conversion.

➦ Convertible securities are issued to reduce cost of capital, increase the marketability, avoid dilution and deferred equity financing.

➦ Securities having convertible features are generally sold with less coupon rate or dividend rate than securities having no convertible feature.

➦ Some firm may have poor financial status but have future growth at that time firm can sell convertible securities at higher price than prevailing price.

➦ With the help of convertibles firm control the control position. Securities having convertible feature are more attractive than without convertible feature.

Features of Convertibles

Table of Contents

Convertibles have various features that help to better understand. Some key features are as follows;

1. Conversion Ratio (#)

➦ It refers to the number of common stocks that can be converted for an each debenture or preferred stock. It should be specified at the time of issuance of the securities.

➦ It serves as a critical metric in determining the value proposition of the convertible security, as it directly influences the potential dilution effect on existing shareholders upon conversion.

➨ Conversion ratio = Face value of convertible debenture(or preferred stock)/ Conversion price

2. Conversion Price

➦ It is the price of stock to be paid at the time of conversion of convertible securities.

➦ Usually set at a premium to the current market price of the underlying stock at the time of issuance, the conversion price influences the profitability of conversion.

➦ A lower conversion price offers investors a more favorable opportunity for conversion, potentially leading to earlier or more frequent conversions.

➨ Conversion price = Face value of convertible debenture (or preferred stock) / Conversion ratio

3. Conversion Value

➦ Conversion value of securities is total market value of convertible if they are converted into common stock.

➦ Conversion value of convertible depends upon the market value of common stock since conversion ratio is fixed at the time of issuance.

➨ Conversion value (Cn) = Conversion Ratio (CR) * Market price per share (Pn)

Note: Pn = Po(1+g)ⁿ (Where g = growth rate in stock price.)

4. Initial Conversion Premium

➦ Initial conversion premium is the difference between conversion price and market price of stock at the time of issue. Generally conversion price is higher than market price of stock.

➦ This premium is calculated as the difference between the conversion price of the convertible security and the prevailing market price of the underlying common stock at the time of issuance, expressed as a percentage.

➦ A higher initial conversion premium implies that investors are paying more for the conversion option relative to the current market value of the common stock.

➨ Initial Conversion Premium = [Conversion Price(CP) – Market price per share(P_o)]/ Market price per share(P_o)

5. Conversion Premium

➦ Initially conversion price is higher than market price of stock but in subsequent years, market price of convertible is higher than straight bond value and conversion value at that time premium can be calculated as;

➨ Premium over straight bond value (in percentage) = (Market Price of convertible – Straight bond value)/ Straight bond value

➨ Premium over conversion value (in percentage) = (Market Price of convertible -Conversion value) / Conversion value

6. Minimum Price of Convertible

➦ Minimum price of convertible securities represents the higher value between straight value of bond and conversion value.

➦ It is typically set above the par value of the convertible security to provide a buffer against potential losses.

➦ By establishing a minimum price, issuers aim to maintain the attractiveness and stability of the convertible, mitigating the risk of excessive devaluation and safeguarding investor interests.

➨ Minimum Price of a convertible = Max (Ct,Bt)

7. Conversion Period

➦ Convertibles could be of fixed period conversion or having conversion of any time. It should be stated at the time of issuance if any specific period is given to convertible holder.

➦ This feature offers flexibility to investors, allowing them to time their conversions strategically based on market conditions, stock performance, and personal investment objectives.

➦ A longer conversion period provides investors with a broader window of opportunity for conversion, potentially enhancing the utility and value proposition of the convertible security.

➦ While a shorter period may exert pressure on investors to convert within a limited timeframe, affecting their decision-making process.

8. Straight bond value

➦ It is the intrinsic bond value of bond having no convertible feature. It is also known as investment value or security value.

➦ It is calculated as present value of coupon interest plus present value of maturity value.

➨ Straight bond value (Vn) = I* {1-1/(1+kd)^n}/kd +M/(1+Kd)ⁿ

= I*(PVIFA,kd%,n)+M(PVIF,kd%,n)

9. Market value of convertible

➦ Market value of convertible securities refers to the actual price of convertibles security that is determined through demand and supply of the securities.

➦ The market price of the convertible securities is always higher than that of minimum price due to convertible features.

➦ It means that investor can get fixed return as well as have chance to enjoy capital gain yield if price of stock increase.

10. Yield to Maturity

➦ Yield to maturity is that rate of return which can be earned if securities are held to the maturity.

➦ In other words, YTM is that rate of interest which equates present value of interest payment and present value maturity value to price of security.

➦ It is also called discounting rate of return. YTM can be calculated by solving following equation

➨ Market Price of convertible = Interest (I) × PVIFA_Kd,n + Face value (M) × PVIF_Kd,n

11. Expected rate of return on convertible

➦ Expected return is that rate of return which earned by investors who purchase the securities at specific price and hold specific period.

➦ It is similar to yield to maturity but yield to maturity is return for hold up to maturity and expected rate of return is return for specific period of time.

➦ Expected rate of return can be calculated by solving following equation.

➨ Market Price of convertible = Interest (I) × PVIFA_Kd,n +Call price (C_n) × PVIF_Kd,n

Both yield to maturity and expected return are calculated in the same process.

➨ YTM and Expected return calculation process

12. Conversion parity

➦ Conversion parity is the price paid by investor at particular time for one stock if they are converted into common stock.

➦ It shows the relationship between conversion ratio and market price of stock at particular time.

➨ Conversion parity = Market value of convertible / Conversion ratio

13. Conversion Policy

Conversion can occur at two ways: forced conversion and stipulated conversion.

i. Forced Conversion

➦ Call provision should be mentioned in the time of issue of convertible if firm wants to use the call provision.

➦ Under this policy firm call the bond to force the conversion. Investor can either convert the convertible into common stock or accept the call price.

➦ Generally, in this policy conversion value is higher than call price but if call price is higher than conversion price investor can accept the call price.

ii. Stipulated Conversion

➦ This is the technique of conversion where investors of convertible securities are stimulated to convert into common stock by raising total dividend.

➦ Investors tend to covert the convertible into common stock when total dividend rate is higher than coupon rate of the convertible.

➦ If the total dividend that can be received after conversion (conversion ratio× DPS) exceeds the annual interest amount, investors tend to convert their securities and vice versa.

References

Convertibles: Finance, Bonds & Securities features. (n.d.). StudySmarter UK. https://www.studysmarter.co.uk/explanations/business-studies/corporate-finance/convertibles/
Features of convertible bonds | Finance Strategists. Finance Strategists. https://www.financestrategists.com/wealth-management/bonds/features-of-convertible-bonds/

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Smirti

(Founder of Management Notes)
MBA,BBA.

I am Smirti Bam, an enthusiastic edu blogger with a passion for sharing insights into the dynamic world of business and management through this website.

I hold a MBA degree from Presidential Business School, Kathmandu, and a BBA degree with a specialization in Finance from Apex College,

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Concept of Convertibles – 13 Major Features of Convertibles | Corporate Finance