A bond, for example, has a conversion ratio of 5, meaning that one bond can be exchanged for five shares of common stock. The price of the bond divided by the conversion ratio is the convertible security’s conversion price. If the bond’s par value is $1000, the conversion price is $200, which is found by multiplying $1000 by 5. The conversion price reduces to $100 if the conversion ratio is ten. As a result, for the security to be converted, the market price must catch up to the conversion price. A lower conversion ratio leads to a lower conversion price, whereas a greater conversion ratio leads to a higher conversion price.
How can you figure out how much a convertible bond’s floor is worth?
Add 1 to the YTM of the non-convertible bond and divide by the number of times the convertible bond pays interest yearly. Divide 4.5 percent (0.045) by 2 to get 0.0225 in this example. To get 1.0225, multiply 1 by 1. Multiply the number of installments per year by the maturity period of the convertible bond.
What is the worth of my convertible notes?
In theory, the basic notion for valuing a convertible note is the same as for any other financial instrument. The present value of the future income that the convertible note will receive, discounted to the present value depending on its associated risk, is the note’s value.
This procedure necessitates determining the estimated future cash flow as well as the required rate of return for discounting the convertible note. The needed rate of return varies each company, although a return on similar notes in the public market can be used as a benchmark.
Before we go into the specifics of convertible note valuation, let’s review the key characteristics of a note:
- The principle amount (or par value) is the total amount borrowed by the corporation from the borrower and due back on the maturity date.
- A coupon rate (interest rate), which is the interest earned and paid to the note holder on a regular basis. This interest is usually in the form of cash, but it can also be in the form of stock.
- There are also no-interest bonds, sometimes known as zero coupon bonds or convertible notes. The par value of this simplified type of note is frequently discounted.
- Depending on the terms of the convertible note, the option to convert the debt amount into business shares exists. Other considerations such as the conversion trigger amount, valuation cap, early exit multiple, conversion discount, and others may also be considered.
What makes valuing a convertible bond so difficult?
The principal benefit of a convertible bond to the issuer is that the bond will typically be issued with a lower coupon rate than a non-convertible bond. Because the holder of a convertible bond is compensated with the opportunity to convert the bond into the issuing company’s equity, this is the case. If new shares must be issued as a result of the conversion, dilution may occur.
Because of the underlying qualities, valuing a convertible bond is more complex. The underlying bond and stock details must be considered while pricing. The equity price, maturity, coupon, volatility, and spread, for example, must all be taken into account. The first approach, which was introduced in version 10, employs a trinomial tree, while the second method, which was introduced in version 10, uses a partial differential equation method, especially the Crank-Nicolson finite-difference method.
What is a convertible bond’s straight bond value?
- The issuer pays the convertible bond holder a periodic interest payment known as a coupon. It could be either constant or variable, or it could be zero.
- Maturity/redemption date: The date on which the bond’s principal (par value) and any outstanding interest must be paid. There is no maturity date for non-vanilla convertible bonds in some situations (i.e. permanent), which is common with preferred convertibles (e.g. US0605056821).
- Final conversion date: The last day on which the holder can request a share conversion. It’s possible that this date differs from the redemption date.
- If the bond offers a premium redemption, the yield on the convertible bond at the issuance date may differ from the coupon value. In those instances, the premium redemption value and intermediary put redemption value would be determined by the yield value.
- The value of a convertible bond’s fixed income aspects (regular interest payments, payment of principal at maturity, and a superior claim on assets relative to common stock) minus the capacity to convert into shares is known as the bond floor.
- Either a conversion ratio or a conversion price will be stated in the issue prospectus. When an investor exchanges a bond for common stock, the conversion ratio is the number of shares received. When exchanging a bond for common stock, the conversion price is the price paid per share to obtain the shares.
- The price that a convertible investor effectively pays for the right to convert to common stock is known as the market conversion price. It’s calculated in the following way. Once the underlying stock’s actual market price reaches the market conversion price incorporated in the convertible, every additional increase in the stock price will push up the convertible security’s price by at least the same proportion. As a result, the market conversion price serves as a “break-even point.”
- The difference between the market conversion price and the current market price of the underlying stock is known as the market conversion premium. Convertible bond buyers accept a conversion price in return for the fixed income characteristics of a convertible bond, which give downside protection. The price of the convertible bond will not fall below the bond floor value as the stock price falls. The market conversion premium is calculated as follows, usually on a per-share basis:
- Parity: The immediate value of a convertible if it is converted, calculated by multiplying the current stock price by the conversion ratio given in terms of a base of 100. Exchange Property is another name for it.
- Call features: The issuer’s capacity (on some bonds) to call a bond for redemption early. This is not to be confused with a call option. A softcall is a call feature in which the issuer can only make a call under specific conditions, usually dependent on the underlying stock price performance (e.g. current stock price is above 130 percent of the conversion price for 20 days out of 30 days). A Hardcall feature would not require any restrictions beyond a deadline: the issuer would be free to recall a portion or the entire issuance at the Call price (usually par) after a deadline.
- Put features: The capacity of the bond’s holder (lender) to compel the issuer (borrower) to repay the loan before the maturity date.
- Every three or five years, these appear as windows of opportunity, allowing holders to use their right to an early payback.
- Convertible bondholders’ capacity to convert into equity is limited by contingent conversion (also known as CoCo). Restrictions are typically based on the underlying stock price and/or time (e.g. convertible every quarter if stock price is above 115 percent of the conversion price). In that regard, reverse convertibles could be viewed as a variant of a Mandatory with a contingent conversion clause. Some CoCo issuances in recent years have been based on Tier-1 capital ratios for some significant bank issuers.
- Reset: Depending on the performance of the underlying stock, the conversion price will be reset to a new value. In most circumstances, this would be in the event of poor performance (e.g. if stock price after a year is below 50 percent of the conversion price the new conversion price would be the current stock price).
- Change of control event (aka Ratchet): In the event of a takeover of the underlying company, the conversion price would be recalculated. There are several types of ratchet formulas (e.g., Make-whole base, time dependant…), and their influence on bondholders can range from minor (e.g., ClubMed, 2013) to considerable (e.g., ClubMed, 2013). (e.g. Aegis, 2012). This clause sometimes includes the power for convertible bondholders to “put,” or request an early return of their bonds.
- Non-dilutive: With reduced interest rates (e.g. in the Euro), the non-dilutive feature has become more common, making convertible issuance remain appealing to issuers who already benefit from low interest rates in the straight bond market. The issuer would simultaneously enter into an OTC option agreement with the underwriter in a non-dilutive placement (or a third party). This option would frequently match the convertible’s strike as well as its maturity. If the stock price is above the strike, this will cancel out the dilution in the case of a convertible conversion at maturity. Typically, the convertible prospectus would limit the potential of early conversion to entirely prevent dilution.
Why are convertible bonds more expensive?
- A conversion premium is the additional value that a convertible security has because it can be converted.
- The premium is due to the fact that, once converted, the investor would hold more equity shares than he or she did previously.
- Some traders utilize convertible arbitrage methods to take advantage of market excess conversion premiums.
- The conversion premium is an important factor in determining the payback duration of a convertible.
Do convertible bonds count as stock?
A convertible bond is a fixed-income corporate financial investment that pays interest but can be exchanged into a set number of common stock or equity shares at a later date. Converting a bond to stock can be done at any time throughout the bond’s life and is normally done at the bondholder’s choice.
What does a convertible’s floor value imply?
Convertible bonds are a type of hybrid financial instrument that can be converted into common stock at the discretion of the bondholder or the company if certain price criteria are met. The convertible bond’s floor value is the lowest price at which the bond can fall and at which the conversion option becomes worthless. It’s critical to understand how to calculate this value so you can sell or convert bonds while they’re still valuable.
What are the two components of the value of a convertible bond?
According to Joseph Mariathasan, the hybrid character of convertibles creates valuation issues and trading opportunities.
A convertible bond is a corporate bond with an imbedded equity option that allows the holder to swap the bond for a certain number of shares at any time. As a result, a convertible bond has the characteristics of both bonds and stocks, with the upside potential of the stock market and the downside protection of bonds, making them appealing to a wide spectrum of investors.
Convertible bonds are issued for a variety of reasons, ranging from the belief that they are a less expensive source of financing than straight debt to the belief that they have a greater conversion price than a rights issue striking price. There may be tax and accounting issues to address. Convertibles are also frequently used in mergers and acquisitions because bids can offer a larger income on a convertible than the dividend yield on the acquired company’s shares without having to boost the dividend yield on all of the bidder’s shares.
The value of a convertible bond as a straight bond is called the investment value; the value as a share is called the conversion value; and the theoretical fair value, which includes the value of the option and is almost always higher than either of the other two valuations, is called the theoretical fair value. The stock price, the exercise price, the interest rates over the period of the option, and – most significantly – the share price volatility all play a role in determining the fair value of a convertible. As a result, valuing a convertible is strongly reliant on a forecast of future share price volatility.
A convertible’s investment value is essentially the same as it would be if it were a regular corporate bond with no options. As a result, the investment value is established by the standard criteria for valuing corporate bonds: the current government bond yield curve’s form and the acceptable credit spread. The investment value is independent of the share price, as shown in the chart on page 6, as long as the company is not in crisis. If the stock price falls, the company’s creditworthiness deteriorates, resulting in an increase in the spread on all of its bonds, including convertibles. The investment value of the convertible will generally be lower than its par value because the coupon will be smaller than that of a straight bond, which will be priced at par.
The investment premium is the percentage difference between the market value of a convertible and its investment value. So, at the time of issuance, the investment premium on a bond with a par value of 1,000 and an investment value of 878.90 would be (/878.90) or 13.8 percent. The higher the premium, the more sensitive the market price of the convertible is to a drop in the share price, and the less downside protection is provided: a larger drop in the share price would be required before the convertible starts approaching its investment value, which would provide downside protection if the company is not distressed.
The offering prospectus for a convertible states the share price equal to the par value of the bond at the time of issue. If the share price is 50, for example, each convertible bond represents 20 shares (par value of 1,000 divided by conversion price of 50). Clearly, the price of a convertible bond will fluctuate above or below par value once it is issued, but it will always be exchangeable for the same number of shares, known as the conversion ratio.
The conversion value is the convertible’s equity value, or what it would be worth if it were converted into shares at current market values. The conversion value is shown by the diagonal line in the graph because it is directly proportionate to the share price.
The conversion premium is the difference between the convertible’s current market price and the conversion value, represented as a percentage of the market price. The convertible bond holder is willing to pay a premium over the conversion value since the convertible bond is more secure than equity and generally offers a greater yield than stock dividends. The value of the convertible converges with the value of the equity as the share price rises, lowering the conversion premium.
Due to the availability of efficient arbitrage mechanisms in the convertible market, there is a high possibility of economic convergence between a convertible’s components and its hedge in normal circumstances. Hedge funds, unsurprisingly, have historically driven much of the market for convertible bonds.
Depending on where the convertible’s fair value is in relation to stock and bond valuations, hedge funds can arbitrage the value of the convertible with the value of its component pieces in a variety of ways. The failure of crucial aspects of the arbitrage strategy, in particular the drying up of the debt markets and the ban on short sales of financial stocks, which made for a large part of the convertibles strategy, resulted in massive losses in convertible arbitrage funds recently.
It might be considered a deep-in-the-money option when the fair value is in the range where the convertible bond exhibits equity characteristics. With no net exposure to the share price, hedge funds would sell the shares and buy the convertible. The return would be the coupon plus the interest earned on the short stock position, less the cost of borrowing the stock and the cost of dividends foregone because the stock was not owned.
The proceeds from the short stock position can be utilized to acquire more convertibles, making these trades highly leveraged. The company’s dividend growth or special dividends, the recall of borrowed shares, or the bonds being called are all hazards. When the short-sale restriction went into effect, funds were required to sell convertibles and buy back shares, regardless of price levels, and the leverage inherent in this sort of arbitrage amplified the implications, causing major market dislocations.
The option-like aspects of the convertible bond are at their peak when the fair value is in the zone where the convertible bond exhibits hybrid characteristics, as evidenced by the high value of the conversion premium.
In this zone, hedge funds can engage in a ‘volatility trade,’ in which they buy the convertible and sell the stock to generate a ‘delta neutral’ position with no exposure to modest market movements. However, even for tiny market swings, the ratio of stock sold for this to be the case varies greatly, therefore the arbitrageur must compute delta using a theoretical model.
Estimating the delta of a convertible bond requires some skill, especially in Asia, where stock borrowing may be prohibited. The stock is sold when the price of the stock rises and acquired when the price of the stock falls, resulting in a market neutral position. The returns come from a combination of static returns (coupon + interest rebate from short stock minus stock borrow fee minus dividends foregone) and re-hedging gains. The risks include inaccurate interest rate assumptions, worsening of issuer credit, stock volatility, stock borrow recall risk, and issuer takeover without protections for convertible holders.
Convertibles can be seen of as bonds paired with out-of-the-money options with limited equity sensitivity when the fair value is in the zone where the convertiblebond exhibits fixed income characteristics (low delta). Convertibles, sometimes known as ‘busted’ convertibles, are frequently mispriced as compared to straight bonds. Hedge owners often unwind positions as the convertible falls to this value range, regardless of how much the credit is worth.
Bonds attract a new set of investors. However, despite the minimal optionality, any big rise in the stock will benefit convertible holders. The convertible bond will trade on a higher delta if the issuing company approaches insolvency or the economy undergoes a substantial macro adjustment. Any arbitrage in this price range necessitates a thorough credit examination.
Companies issue convertible bonds for a variety of reasons.
- Convertible bonds are corporate bonds that can be exchanged for the issuing company’s common stock.
- Convertible bonds are issued by companies to cut debt coupon rates and defer dilution.
- The conversion ratio of a bond decides how many shares an investor will receive in exchange for it.
- Companies can force bond conversion if the stock price is higher than the bond’s redemption price.