What is a convertible bond?
A convertible bond is a fixed-income corporate debt security that yields interest payments, but can be converted into a predetermined number of common stock or equity shares. The conversion from the bond to the stock can be done at certain times during the bond’s life and is usually at the discretion of the bondholder.
Convertible bonds are an alternative funding mechanism for companies. The world-wide corona virus pandemic has meant that raising long-term bank loans has become particularly difficult, causing borrowers to choose the capital markets in preference. Convertible bonds are a cheaper cash source of funding for the issuer as it is subsidized by the embedded equity option.
Convertible bonds are at first treated as bonds, but can be converted into shares of the issuing company after a certain time period. The investor’s decision to convert into equity is dependent on the share price at that point in time. The instrument therefore has a debt element (the bond) and an equity element (the option to convert the bond into shares). The debt element ensures that a regular interest payment is made to investors and provides the protection mechanisms of a senior debt claim into the company. The equity element means investors can convert the bonds into equity in the company after a certain time period but would consider doing so only once the share price at least exceeds the conversion price.
A company could consider issuing a convertible bond for the following purposes: refinancing existing debt; growth/acquisitions; capital optimization; low cash cost; raise long term funding; and is less dilutive than equity.
Convertible bonds are also quicker to get in the market, mostly because they don’t require a credit rating, and due to the convertible bond being linked to the company’s share price.
Convertible bonds are also quicker to get to the market mostly because they don’t require a credit rating, and due to the convertible bond being linked to the company’s share price, execution into the market is limited to one or two days.
They are ideal for entities looking to raise funding over a short period of time for expansion or acquisitions. When compared to equity funding, the dilutionary effect on a company’s issued shares is less than that when issuing straight equity while the issuer also receives tax benefits, as interest payment on bonds should be tax deductible based on the use of funds, whereas dividends on shares are paid from after-tax profits.
How to Price a Convertible Bond: while various inputs and considerations are used in pricing the coupon (or interest rate) for a convertible bond, including the ultimate structure of the instrument, the main drivers include the volatility and dividend yield of the underlying listed equity share, and the credit quality of the underlying issuer.
Note that the greater the volatility of the underlying share, the more valuable the embedded option and the greater the reduction in the cash coupon of the convertible bond. The higher the expected yield on the share, the greater the amount of the value which is expected to be paid out of the issue prior to the conversion.
Convertible Bond Example: to illustrate the difference of an investor buying a company X share, a corporate bond or a convertible bond. The following assumptions are made:
ü The current share price of company X is $100
ü An investor has $10,000
ü The investor has three different instruments to choose from.
The investor could choose between:
Option 1. 100 shares in company X and a dividend yield of 3%
Option 2. A vanilla bond with a per value of $10,000 and an annual interest of 10%, which is a coupon of $1,000 per year.
Option 3. A convertible bond which has a par value of $10,000 and interest paid of 7%. The convertible bond pays lower interest than the vanilla bond because of the embedded option. Assuming the conversion price on the convertible bond is set at $130, a convertible bond with par value of $10,000 can be converted into 77 company X shares. The number of shares is known as the conversion ratio and is calculated by dividing the par value of the bond with conversion price. Another interpretation of the conversion price is that it is the minimum price for which a conversion of the bond into shares would be equal the principal amount of the convertible bond is $10,000.
Option 1. Company X shares
Holding company X shares means that the investor enjoys the upside when the share price rises but also suffers the losses when the share price drops.
Option 2. Vanilla bond
The vanilla bond’s coupons are calculated on the par value of the bond i.e., $10,000. Therefore, the movement in the company X share price does not affect the pay-off that the investor receives on the vanilla bond.
Option 3. Convertible bond
The investor would have limited downside risk but an upside gain. When the company X share price falls to $50, the embedded option is out-of-the-money because the share price is less than the conversion price. The investor can thus choose not to exercise the option but to continue receiving the annual coupon of $700 and the $10,000 on maturity of the convertible bond.
In all, businesses can always key in on convertible bonds as a means of alternative funding option.