Convertibles Bond

“convertible bonds are low coupon bonds with

an attached call option held by the
bondholders”
Key Concepts and Skills
 Understand how convertible bonds are similar
to call options
 Understand how convertible bonds differ from
call options
 Understand why corporations would issue
convertible bonds

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Chapter Outline
1. Convertible Bonds
2. The Value of Convertible Bonds
3. Reasons for Issuing Convertibles
4. Why are Convertibles Issued?
5. Conversion Policy

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1. Convertible Bonds
 A convertible bond gives the holder the right to exchange it for a
given number of shares of stock anytime up to and including the
maturity date of the bond..
 The most important difference is that a bond with warrants can be
separated into different securities and a convertible bond cannot.
 Recall that the minimum (floor) value of a convertible is the
maximum of:
 Straight or “intrinsic” bond value
 Conversion value
 The conversion option has value.

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2. The Value of Convertible Bonds
The value of a convertible bond has three
components:
1. Straight bond value
2. Conversion value
3. Option value

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Convertible Bond Example
 Litespeed, Inc., just issued a zero coupon convertible
bond due in 10 years.
 The conversion ratio is 25 shares.
 The appropriate interest rate is 10%.
 The current stock price is $12 per share.
 Each convertible is trading at $400 in the market.
 What is the straight bond value?
 What is the conversion value?
 What is the option value of the bond?

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Convertible Bond Example
 What is the straight bond value?
$1,000
SBV  10
$385.54
(1.10)
–What is the conversion value?

25 shares × $12/share = $300

–What is the option value of the bond?

$400 – 385.54 = $14.46

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 OPTION VALUE The value of a convertible bond will
generally exceed both the straight bond value and the
conversion value.
 When the value of the firm is low, the value of convertible
bonds is most significantly influenced by their underlying
value as straight debt. However, when the value of the firm is
very high, the value of convertible bonds is mostly
determined by their underlying conversion value. This is
illustrated

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The Value of Convertible Bonds
Convertible
Bond Value
Convertible bond
values Conversion
Value
floor value

floor Straight bond

value value
= conversion ratio Option
value
Stock
Price 24-9
3. Reasons for Issuing Convertibles
 A reasonable place to start is to compare a hybrid like convertible debt to
both straight debt and straight equity.
 Convertible debt carries a lower coupon rate than does otherwise-
identical straight debt. Investors will accept a lower interest rate on a
convertible because of the potential gain from conversion
 Since convertible debt is originally issued with an out-of-the-money call
option, one can argue that convertible debt allows the firm to sell equity
at a higher price than is available at the time of issuance. However, the
same argument can be used to say that it forces the firm to sell equity at a
lower price than is available at the time of exercise.

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Convertible Debt vs. Straight Debt
 Convertible debt carries a lower coupon rate than does
otherwise-identical straight debt.
 If the company subsequently does poorly, it will turn out that the
conversion option finishes out-of-the-money.
 But if the stock price does well, the firm would have been better
off issuing straight debt.
 In an efficient financial market, convertible bonds will be neither
cheaper or more expensive than other financial instruments.
 At the time of issuance, investors pay the firm for the fair value
of the conversion option.

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 The Stock Price Later Rises So That Conversion Is Indicated,…. The
firm clearly likes to see the stock price rise. However, it would have
benefited even more had it previously issued straight debt instead of a
convertible. Although the firm paid out a lower interest rate than it would
have with straight debt, it was obligated to sell the convertible holders a
chunk of the equity at a below-market price.
 The Stock Price Later Falls or Does Not Rise Enough to Justify
Conversion ,….. The firm hates to see the stock price fall. However, as
long as the stock price does fall, the firm is glad that it had previously
issued convertible debt instead of straight debt. This is because the
interest rate on convertible debt is lower. Because conversion does not

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Convertible Debt vs. Straight Equity
 If the company subsequently does poorly, it will turn out that
the conversion option finishes out-of-the-money, but the firm
would have been even better off selling equity when the
price was high.
 But if the stock price does well, the firm is better off issuing
convertible debt rather than equity.
 In an efficient financial market, convertible bonds will be
neither cheaper or more expensive than other financial
instruments.
 At the time of issuance, investors pay the firm for the fair
value of the conversion option.

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 The Stock Price Later Rises So That Conversion Is Indicated …. The
firm is better off having previously issued a convertible instead of equity.
To see this, consider the Dish Network case. The firm could have issued
stock for $61.98. Instead, by issuing a convertible, the firm will
effectively receive substantially more for a share upon conversion.

 The Stock Price Later Falls or Does Not Rise Enough to Justify
Conversion ….. No firm wants to see its stock price fall. However,
given that the price did fall, the firm would have been better off if it had
previously issued stock instead of a convertible. The firm would have
benefited by issuing stock above its future market price. That is, the firm
would have received more than the subsequent worth of the stock.
However, the drop in stock price did not affect the value of the
convertible much because the straight bond value serves as a floor.

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4. Why Are Convertibles Issued?
 Convertible bonds reduce agency costs by aligning the
incentives of stockholders and bondholders.
 Convertible bonds also allow young firms to delay
expensive interest costs until they can afford them.
 Support for these assertions is found in the fact that firms
that issue convertible bonds are different from other firms:
 The bond ratings of firms using convertibles are lower.
 Convertibles tend to be used by smaller firms with high growth
rates and more financial leverage.
 Convertibles are usually subordinated and unsecured.

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5. Conversion Policy
 Most convertible bonds are also callable.
 When the bond is called, bondholders have about 30 days to
choose between:
1. Converting the bond to common stock at the conversion
ratio.
2. Surrendering the bond and receiving the call price in cash.
 From the shareholder’s perspective, the optimal call policy is to
call the bond when its value is equal to the call price.
 In the real world, most firms wait to call until the bond value is
substantially above the call price. Perhaps the firm is afraid of
the risk of a sharp drop in stock prices during the 30-day
window.

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Quick Quiz
 Explain how convertible bonds and warrants
are similar to call options.
 Explain how convertible bonds and warrants

are different from call options.

 Identify possible corporation benefits from

issuing convertible bonds and/or warrants.

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