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A convertible bond is a security, typically ranging between 25 and 30 years in term, that gives its’ owner the right to acquire the issuers common stock directly from the issuer rather than purchasing it in the open market. The terms under which this exchange can occur are detailed out in the bond indenture. Typically, convertible bonds will be classified as subordinated debt and therefore more risky than unsubordinated debt. Subordinated debt holders are lower on the totem pole as far as principal repayment during times of distress for the issuer.
In the event of bankruptcy, “senior” bond holders will be paid their credit balance before subordinated debt holders. Conversion Ratio – This ratio determines the number of shares the bond holder will receive per bond they exchange. The formula for the conversion ratio is: Par Value of Convertible Security divided by Conversion Price. Parity – Conversion parity is the point at which a profit, nor loss, would be made at conversion.
Basically, parity exists when the conversion ratio at issuance is equal to the convertible security price divided by the market value of the stock. When the price of the stock increases above the conversion parity price, the convertible security would be subject to price changes relative to the movements of the stock. When this condition exists, stock price appreciation will be reflected in the price of the bond which will allow the bond holder to sell the convertible security for a profit rather than performing a conversion and then selling the stock for a gain. Conversion Premium – The conversion premium measures the spread between the conversion price and the current market value in percent. Secondly, through the issuance of convertible debt, issuers avoid dilution of their common shares and therefore, higher stock prices for their shareholders. The analysis would need to be done for the issuer to understand if the interest expense of the convertible debt issuance would be less than the cost of diluting the common stock. For start up companies with lower revenues, this is most likely the case.
The call feature would allow the issuer to force the bond holder to convert their bonds at a lower price. For example, suppose the indenture stated that the convertible bond could be exchanged for 10 shares of common stock and also assume that the issuer built in a call provision that would allow them to call the bond away at a bond price of 110. 120 per share which also moved the bond price to 120. One key disadvantage to the issuer of a convertible exists if the stock price increases so rapidly that the conversion takes place in a relatively short amount of time. A second, and more negative scenario, exists when the common stock actually moves lower after issuance. In this case, the bond holder will not convert to equity as the issuer had hoped.