Convertible Bonds

1. Convertible Bonds • General issues • Price of a convertible bond • Conversion price of the stock • Risks associated with Convertible Bonds

2. General Issues Convertible bond: a corporate bond with a call option to buy the common stock of the issuer. Exchangeable Bonds grant the bondholder the right to exchange the bonds for the common stock of a firm other than the issuer of the bond. Conversion ratio: the number of shares of common stock that the bondholder will receive from exercising the call option of a convertible/exchangeable bond

3. Conversion Price • Conversion price = par value/conversion ratio (at the issuance of a convertible bond)

4. Other Features • Physical settle versus cash settle • Put provision: grants the bondholder the right to sell the issue back to the issuer at par value on designated dates (page 5). • Hard put versus soft put

5. Minimum Value of a Conversion Bond • the greater of • Its conversion value • Its value of corporate bond without the conversion option

6. Example • Maturity = 10 years • Coupon rate = 10% • Conversion ratio = 50 • Current market price of the bond = $950 • Current price of the stock = $17 • Dividend per share = $1

7. Example • What is the conversion price of the bond? • What is the minimum value of the bond?

8. Market Conversion Price • Market conversion price = market price of convertible bond/conversion ratio • Market conversion premium per share • = market conversion price – current market price • Market conversion premium ratio=conversion premium per share/market price of common stock

9. Example • At a market price of $950, a stock price of $17, and a conversion ratio of 50, calculate (1) the market conversion price, (2) market conversion premium per share, and (3) market conversion premium ratio of the bond.

10. Why Convertible Bonds? • Stock price is low, selling stocks could dilute the price of the stock.

11. Exercises • chapter 18: Problem 6