Convertible bond

A convertible bond is two instruments sold as one. The workbook puts it exactly: a plain vanilla bond plus an embedded equity conversion option. It gives the bondholder the right to exchange the bond for a specified number of common shares of the issuing company.

So the holder gets a floor and an upside. If the company does badly, the bond is still a bond — coupons keep coming and the principal is repaid. If the shares run, he converts and participates as a shareholder.

Options are not free, and this one is paid for in coupon. A convertible pays less than the same issuer's ordinary debt of the same maturity. The buyer gives up current income to buy the possibility of equity.

Bonds with embedded options come in three forms, and the workbook groups them together. Two of them belong to the issuer or the holder on the debt side, and one crosses into equity:

• Callable bond — the issuer may redeem early. Bad for the holder, who loses a high coupon just when rates have fallen; yield to call measures the return to the first call date.
• Puttable bond — the holder may sell the bond back to the issuer at a pre-determined price on specified dates. Beneficial to the bondholder, because it guarantees a selling price.
• Convertible bond — the holder may exchange it for a fixed number of shares.

The conversion terms are fixed at issue, which sets an implied conversion price: face value divided by the number of shares received. Whether conversion is worth taking is then a single comparison — market price of the share against that conversion price.

The option sits with the holder, so it is exercised only when it pays. That asymmetry is what the reduced coupon buys.

Conversion price = Face value of the bond / Number of shares on conversion

Conversion value = Number of shares on conversion x Current market price per share

Convert when:  Conversion value > Value of the bond held to maturity

A mid-cap company issues a Rs 1,000 face value convertible debenture, 7% coupon, 5-year tenor, convertible at the holder's option into 40 equity shares. Its ordinary non-convertible debt of the same tenor pays 9.5%.

Conversion price = 1,000 / 40 = Rs 25 per share

The price of the option. The holder gives up 250 basis points of coupon:

Foregone income = Rs 1,000 x 2.5% x 5 years = Rs 125 per bond

Outcome A — the share is at Rs 20 at maturity.

Conversion value = 40 x 20 = Rs 800   -> worse than Rs 1,000 redemption

He does not convert. He is repaid Rs 1,000, having collected Rs 70 a year. The option expired worthless, and the Rs 125 of foregone coupon was the premium he paid for a protection he did not need.

Outcome B — the share is at Rs 38.

Conversion value = 40 x 38 = Rs 1,520
Gain over redemption       = Rs   520 per bond
Less coupon foregone       = Rs   125
Net benefit of the option  = Rs   395 per bond

On a holding of 200 debentures (Rs 2,00,000 face value) that is Rs 79,000 of net benefit — for having accepted 7% instead of 9.5% for five years.

The issuer's side. Conversion extinguishes Rs 2,00,000 of debt and issues 8,000 new shares instead. The company's borrowing disappears without a cash repayment, but the existing shareholders' stake is diluted by those 8,000 shares.

Chapter 9 (Investing in Fixed Income Securities), in the discussion of bonds with embedded options, where callable, puttable and convertible bonds are defined together, just before section 9.3 on the risks of fixed income securities. Questions ask which party holds the option in each case and who benefits, and place convertible bonds correctly in the debt-versus-equity spectrum.

• The conversion option belongs to the holder, not the issuer. The call option in a callable bond belongs to the issuer — the exam pairs these two and swaps them.
• A convertible pays a lower coupon than comparable straight debt. If a question shows a convertible yielding more than the issuer's plain bond, something else is going on.
• Conversion is a right, not an obligation. A holder who does not convert is simply repaid at par.
• Puttable bonds are beneficial to the bondholder; callable bonds increase the risk for the investor. The workbook states both directions explicitly.
• Conversion dilutes existing shareholders. New shares are issued; the debt is not repaid in cash.
• Until conversion it is a bond, and carries a bond's risks — downgrade risk, spread risk and default risk all still apply.
• Do not confuse it with a convertible preference share, which is equity carrying a preferential dividend, not a debt instrument.