I. Convertible Bond. A convertible bond is one which is convertible into the company's common stock. The conversion option to the bond is exerciseable when and if the investor wants to do it. The conversion ratio varies from bond to bond. The terms of conversion are set forth in the indenture. The exact number of shares or the method of determining how many shares the bond is converted into is printed in the indenture.
Many times the indenture will tell you how many shares of stock the bond is convertible into. For instance, it might say that it is convertible into 20 shares. Therefore, the conversion ratio is 20:1. Unfortunately, it's not always that easy. For instance, the indenture might state the conversion price. The conversion price is the price per share that the company is willing to trade their shares of stock for the bond. For example, if the indenture states that the conversion price is $50 per share, the bond is convertible into 20 shares of stock. You divide the par value (usually $1,000 for corporate bonds) by the conversion price. Occasionally, the indenture might state that the conversion ratio will change through the years. For example, the conversion price might be $50 for the first five years, $55 for the next five years, and so forth. There are also anti-dilutive features to the conversion feature. If the stock were to split 2 for 1, and the conversion ratio was 20 to 1 prior to the split, after the split, the conversion ratio would be 40 to 1. A stock dividend would also have the same effect. A stock split would also reduce the conversion price.
Because convertible bonds have a little something extra, the right to convert to common stock, that little something extra costs the bond holder. The bond will usually carry a slightly lower interest rate. If the stock price rises, the bond price will also rise. Since most convertible bonds are also callable, the company can force the bond holders to convert the bonds to common stock by calling the bonds. This is known as 'Forced Conversion'. When a bond is converted to common stock, the corporate debt is reduced. What was formerly debt has now been converted to equity. Of course, converting debt (bonds) into stock (equity) has the effect of diluting the equity. The company didn't get any larger with the additional stock. But each stockholder's piece of the pie got smaller. If the company's stock declines to a price which makes the convertible feature of the bond worthless, as long as the company is solvent, the bond will trade based on its yield - like any other bond. There is a price level to which a bond will fall and fall no further as long as the company can pay its interest and the principal upon maturity.
One other term to know is 'Parity'. If the $1,000 convertible bond is convertible into 50 shares of stock, the parity price of the stock is $20. If the stock moves up to $25, for the stock and bonds to be at parity, the bonds would have to be trading at $1,250. A convertible bond provides the performance attributes of common stock and a bond. These securities typically pay a semi-annual coupon of 4.00% to 5.00%. The security is typically a subordinated debenture with a fixed principal amount and time to maturity with a right to convert into common stock based on its conversion ratio. The upside of the convertible comes from its common stock component, while the downside protection comes from the cash coupon, fixed maturity, and status in the capital structure which is senior to common and preferred stock.
II. Convertible Preferred. A convertible preferred also has features similar to a convertible bond. However, convertible preferred stock is subordinated to debt of the issuing company. It typically offers a coupon of 6.00% to 7.00%. A convertible preferred typically pays a cash coupon on a quarterly basis, and is also perpetual or with a long maturity.
III. Valuation: For equity oriented investors, convertibles can be viewed as either a Stock plus Put, or Bond plus Call.
IV. Some Definitions (from Campbell Harvey's Glossary)
V. Some Variations
Mandatory Convertibles (PEPS). PEPS, or Participating Equity Preferred Shares, are a type of convertible security that is designed to provide investors with high current income along with high equity-like participation in the underlying stock. PEPS usually provide a coupon of 6.00% to 8.00% and are issued with relatively low premiums of 18% to 23%. The PEPS coupon is usually paid quarterly. These securities typically mature in 3 to 5 years, are typically listed, and are usually call protected for most of their life.
PHONES, ZONES and ZENS. These securities are usually issued at the same price as the common with an exchange premium of 5.26%. They typically have a yield that is 1.50% to 2.00% greater than the common dividend, and in most cases this coupon is subject to any additional common stock dividend distribution. PHONES typically have maturities of 30 years. These securities can be exchanged at any time into a cash value equal to 95% of an average price of the underlying common stock over a period of trading days. For taxable investors, these securities do have a negative phantom tax implication. These securities are typically callable at any time at a call price equal to the higher of the issue price or the market value of the underlying common stock, plus a coupon make whole that gives holders any unpaid coupons for the first three years of the security’s term.
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