Convertible Bond

The indenture fixes a conversion ratio, the number of common shares received per bond surrendered. Dividing par value by that ratio gives the conversion price, the effective per-share cost at which debt is exchanged for equity. Conversion value at any moment is simply the conversion ratio multiplied by the current share price; it is what the holder would receive immediately upon exercising.

Dividing the bond's market price by the conversion ratio produces the market conversion price, the share price an investor is effectively paying by buying the bond and converting. The excess of that figure over the actual share price is the market conversion premium per share, and expressing it as a proportion of the share price gives the market conversion premium ratio. Anti-dilution clauses adjust the ratio for stock splits, stock dividends and certain distributions, protecting the holder's economic claim.

A convertible's minimum value is the greater of its conversion value and its straight value, the price the same cash flows would command as ordinary debt of that issuer. The straight value acts as a bond floor, though it is not fixed: it erodes if credit quality deteriorates, which is precisely when the equity leg also weakens, so the floor is soft rather than absolute.

Most convertibles carry additional embedded options. An issuer call allows redemption once the shares trade above a threshold, which in practice forces conversion because holders prefer shares worth more than the call price. This truncates upside and is why a callable convertible is worth less than an otherwise identical non-callable one. Putable convertibles add value to the holder. Valuation therefore combines a straight bond, a long call on the equity, and short or long positions in these ancillary options.

Convertibles behave differently depending on where the share price sits. Deeply out of the money, the security trades near its straight value and responds mainly to interest rates and credit spreads; it is often described as busted or bond-like. Deeply in the money, it tracks the equity almost one for one and is termed equity-like. Between the two it is hybrid, showing partial equity sensitivity and the convexity that attracts convertible arbitrage funds, who buy the bond and short a delta-weighted quantity of stock to isolate volatility and credit exposure.

Issuers use convertibles to cut cash coupon costs, to raise capital when straight debt is expensive or unavailable, and to sell equity at an effective premium to the current share price. On the financial statements, potential conversion enters diluted earnings per share, and the shares issued on conversion dilute existing holders.

At Level I you should compute the conversion ratio from par and conversion price, calculate conversion value from a given share price, derive market conversion price and premium per share from the bond's quoted price, and convert the premium into a ratio. You should also identify the minimum value as the higher of conversion value and straight value, and recognise the premium payback period as the time needed for the convertible's income advantage over the shares to recoup the conversion premium.

Equally testable is qualitative reasoning: ranking the values of otherwise identical straight, convertible, callable convertible and putable convertible bonds; explaining why the convertible underperforms the shares when the stock rallies sharply but outperforms when it falls; and articulating the issuer's motivation for accepting future dilution in exchange for a lower coupon.