Convertible bonds allow holders to opt for shares

Written by Sunil K Parameswaran | Updated: May 31 2013, 09:10am hrs
Most bonds are plain vanilla in nature. Such bonds pay interest or coupons at periodic intervals, typically every six months, and repay the principal at maturity. Some bonds, however, have built in options. One such option is the flexibility to convert the bond into shares. Such bonds are known as convertible bonds.

The number of shares which a holder will get on conversion is referred to as the conversion ratio. Thus if a bond with a face value of R1,000 is convertible into 40 shares, we say that the conversion ratio is 40. The conversion ratio may decline over time. This would be the case if the issuer anticipates that his stock is likely to become more valuable with the passage of time. For instance, a company in a relatively virgin area may specify that a holder will get 40 shares if he were to convert before a certain number of years, but only 32 shares later on.


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Since the share price will decline in the event of corporate actions like stock splits and bonus shares, the conversion ratio will have to be adjusted in such situations. Such actions will lead to a reduction in the market price of the security, and the conversion ratio will need to be adjusted upwards.

Since such bonds confer the holder with an option, they will usually carry a lower coupon than a plain vanilla issue. The way to look at it is as follows: If an issuer has to take a decision between issuing a plain vanilla bond or a convertible bond with the same maturity, then the convertible can be issued with a lower coupon. Subsequently, if we compare a convertible with a plain-vanilla bond with otherwise similar characteristics such as coupon, liquidity, maturity, and risk quality, we will find that the convertible carries a higher price or offers a lower yield. In the case of convertible bonds, the option premium built in to the security will manifest itself as a higher price, or equivalently a lower yield.

In many cases, convertible bonds will also be callable in nature. That is, they will offer the issuer an option to redeem the bonds prior to maturity. Such call options can be used by the issuers to force conversion. That is, when confronted with the spectre of recall, a bondholder may deem it appropriate to convert the bond into shares, rather than countenance the prospect of a return of cash, which will for obvious reasons have to be reinvested at lower interest rates.

The value of the shares if a bond is converted is referred to as its conversion value. For instance, if a bond has a conversion ratio of 40, and if each share is priced at R22.50, then the conversion value is said to be R900.

Another value associated with such bonds is the straight value. To compute the straight value, we have to determine the price of a plain-vanilla bond that is similar in all other respects. The market price of the convertible must be greater than or equal to the greater of its conversion value and its straight value. That is the price must be at least equal to Max (conversion value, straight value).

A variation of convertible bonds are exchangeable bonds. Normally, if we were to convert the bonds of ABC, we would get shares of the same firm. However, in the case of an exchangeable bond, if we were to convert ABCs bonds, we would get shares of XYZ. The firm XYZ may in certain cases be a subsidiary of ABC, while in other cases may represent a firm in which ABC has a stake. By attaching the option to buy shares of XYZ to its bonds, ABC can issue debt with a lower coupon. The conversion option may also be intended to eventually obtain a higher share price for its stake in XYZ against what ABC could get if it were to offload its shares immediately.

change of mind

* Number of shares that a holder will get on conversion is referred to as the conversion ratio

* Share price will decline in the event of corporate actions like stock splits and bonus shares

* Such actions reduce mkt price of security, so conversion ratio will need to be adjusted upwards

* Since such bonds confer the holder with an option, they will usually carry a lower coupon rate

* Convertible bonds may also offer the issuer an option to redeem them before maturity

The writer is the author of Fundamentals of Financial Instruments, published by Wiley, India