TOPIC 5

CHAPTER 20

CONVERTIBLE BONDS

Assigned Problems: 1,3,4,5,6

Excel Assignment: None
Convertible Bond:
If the corporate bond has a call option on a firm other than the issuer of the bond the
bonds are called
1) Dart and Kraft bonds exchangeable for Minnesota Mining and Manufacturing
2) Ford Motor Credit bonds exchangeable for the common stock of the parent company.

+
Straight

=
Equity Option

Convertible Bond

We are going to use this example through the entire lecture:

Maturity: 10 years
Annual Coupon Rate Paid Semi-annually: 15%
Conversion Ratio: 75
Par Value: $1,000
Current market price bond: $900
Current stock price: $10
Dividends per Share: $1

I. The Basics of Convertible Bonds

A. Conversion Ratio:
The conversion ratio is the number of shares of common stock that the bondholder will
receive from exercising the call option of a convertible bond or an exchangeable bond.
Important Points:
1) The conversion privilege may extend for all or only a small portion of the bonds
life
2) The conversion ratio may fall over time
3) The conversion ratio adjusts proportionally for a stock split and stock dividends.
B. Conversion Value:
The conversion value is the value of the bond if it is converted immediately:
Conversion value = market price of common stock * conversion ratio

C. Minimum Price of a Convertible Bond:

Minimum price is the greater of:
1)
2)
Steps to estimate the straight value:
1) Determine the required yield on a nonconvertible bond with the same quality
rating and similar investment characteristics
2) Use that required yield to find the present value of your bond.
Example: If comparable bonds are trading to yield 20%, what is the straight value of this
bond?

What if the market price was less than $787.16?

Example: If comparable bonds are trading to yield 22%, what is the straight value of this
bond?

What if the market price was less than $750?

Bond Price

Conversion Value

Protects
like a bond

Straight Bond Value

Stock Price
D. Market Conversion Premium:
market conversion price

market price of convertible bond

conversion ratio

Market conversion premium per share = market conversion price current market price
Example: Market conversion price:

For the market conversion price to lie above the stock price (the market conversion
premium is positive), the market price of the convertible bond must exceed the
conversion value.
So far, we have discussed that the bond price must be equal to or greater than the price
floor established by the minimum price. However, why would an investor purchase a
convertible bond with a premium?
Here we refer to the right hand side of the above graph, where the conversion value
exceeds the straight value. Investors would be willing to pay a higher price for the
convertible bond (exceeding the conversion value). Why?

That is, the convertible bond acts like a call option (a right to purchase equity at a prespecified price, NOT the right of the issuer to recall the bond though most convertible
bonds have this feature as well). Thus the premium can be thought of as the price of the
call.
What is the difference between a call option and a convertible bond?

E. Premium over Straight Value:

Premium over straight value =

market price of convertible bond

1
straight value

Here we refer to the left hand side of the above graph, where the straight value exceeds
the conversion value. Again, investors would be willing to pay a higher price for the
convertible bond (exceeding the straight value of the bond). Why?

Terminology:
Straight Value>Conversion Value
Bond Equivalent (Busted Convertible)
Trades much like the straight bond

Conversion Value>Straight Value

Equity Equivalent
Trades like an equity instrument
Premium per Share is low

Hybrid Security
Premium exists
II. Why issue convertible debt?
1) advantage of lower borrowing costs
2) less restrictive covenants relative to a non-convertible issue
In other words, the investor pays for the right to participate in future favorable price
changes in the underlying common stock by accepting a lower yield and a less restrictive
debt agreement p. 1106 The Handbook of Fixed Income Securities
How does the return of a convertible bond compare to the underlying stock in the case of
increasing and decreasing stock prices?
Simplifying assumption:
Compare the return from buying the bond or just buying the stock if todays stock price
appreciates to $20.

Premium on convertible bond limits upside potential, making your return less than the
return from holding stock.
What if stock depreciates to $5/share?

Important Risk Considerations:

Call Risk: Issues can be callable by the issuer which forces conversion. The loss
exists if the current market price of the bond is above the conversion value because
you lose the premium.
Takeover risk: if acquired no stocks may exist after the acquisition.
CFA Exam problem:
Simon Evans, CFA, is researching SOC Corporation, a company that has issued both
convertible and straight bonds. A major broker/ dealer makes an over-the-counter market
in options on SOCs common stock. Evans is considering two possible portfolios
Portfolio X: five SOC convertible bonds (total par value $5,000) with a conversion ratio
of 20
Portfolio Y: five SOC straight bonds (total par value $5,000) and a call option for 100
SOC shares
Evans believes that portfolios X and Y are similar in some ways, because each portfolio
holds SOC bonds and rights to own SOC stock. In preparing to make a portfolio decision,
Evans obtained the current information presented in the following table:
SOC Bonds Data
Coupon
Maturity
Conversion Ratio
Market price
Yield to Maturity

Convertible
5.5%
5 years
20.0
93.75
7.0%

Straight
10.5%
5 years
---100
10.5%

SOC call/option data (American Style):

Strike price=$50
Expiration date: 5 years
Call premium: $7.50

1. Certain steps are required to change each portfolio from SOC bonds to SOC common
stock. Using only the information provided here, compare portfolios X and Y with
respect to each of the following:
a. Transactions required to change holdings from bonds to stocks

b. Parties involved in the transactions

c. Potential risks or costs associated with the changes

2. Complete the following table (to calculate the PV of the coupon payments assume a
6% risk free annual discount rate):
Straight SOC
Bonds

Convertible
SOC Bonds

Difference

Cost of Five Bonds

Dollar Amount of Semiannual
Coupon for five bonds

3. Recommend and justify the purchase of either portfolio X or Portfolio Y, using your
analysis in parts a and b.