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Convertible Bonds: Mechanics, Accounting, and Valuation
This post will explore the essential mechanics, complex accounting treatments, and key valuation drivers of these versatile instruments, using practical examples to illuminate their function in modern capital markets.
FINANCIAL
Ryan Cheng
7/1/20256 min read
Convertible bonds occupy a unique and sophisticated space in the world of corporate finance. As hybrid securities, they blend the fixed-income characteristics of traditional bonds with the upside potential of equity, offering a compelling proposition for both issuers and investors. For companies, they represent a method of raising capital at a lower interest cost, with the possibility of converting debt to equity down the line. For investors, they provide the safety net of a bond's principal and coupon payments, coupled with a call option on the company's future growth.
The Conversion Mechanism: From Bond to Equity
Intro
At its core, a convertible bond is a corporate bond that can be exchanged for a predetermined number of the issuing company's common shares. Several key terms govern this process
Par Value
The face value of the bond, typically $1,000, which is repaid to the investor at maturity if the bond is not converted.
Conversion Premium
The amount by which the bond's issue price exceeds the current market value of the shares it can be converted into.
Conversion Price
The effective price per share at which the conversion occurs.
Conversion Ratio
The number of common shares received for each converted bond.
Scenario
A company issues $100 million of convertible bonds, each with a par value of $1,000. The company's stock is currently trading at $66.67 per share, and the bonds are issued with a 50% conversion premium. If the stock price appreciates and investors decide to convert, how many new shares will be created?
Determine the Conversion Ratio
This ratio dictates how many shares one bond can be exchanged for.
Conversion Ratio = Par Value / Conversion Price
10 shares per bond = $1,000 / $100.00
Calculate the Conversion Price
The conversion price is the price at which the bond's value is equivalent to the shares it converts into. It's found by applying the premium to the current stock price.
Conversion Price = Current Stock Price × (1 + Premium)
$100.00 = $66.67 × 1.50
Find the Number of Bonds Outstanding
This is calculated by dividing the total issuance amount by the par value of a single bond.
Number of Bonds = Total Issuance / Par Value
100,000 bonds = $100,000,000 / $1,000
Calculate Total New Shares
Finally, multiply the number of bonds by the conversion ratio to find the total dilution impact.
New Shares Issued = Number of Bonds × Conversion Ratio
1,000,000 shares = 100,000 bonds × 10 shares
Accounting Complexities of Convertible Bonds
The hybrid nature of convertibles leads to specific and sometimes complex accounting treatments, particularly under different standards like IFRS and U.S. GAAP.
Accounting at Issuance
For certain types of convertibles, such as those with a cash-settlement feature, accounting rules require the proceeds to be split between a liability and an equity component.This bifurcation reflects the dual nature of the instrument.
Consider a U.S.-based company that issues a $500 million face-value convertible bond with a cash-settlement option, incurring $5 million in financing fees. The present value (PV) of an equivalent bond without the conversion feature is determined to be $400 million.
Here is how the company would record this on its financial statements:
Liability Component
This is equal to the present value of a similar, non-convertible bond. Liability Component = $400 million.
Equity Component
This is the residual value, representing the worth of the embedded conversion option. Equity Component = Total Proceeds ($500 million) – Liability Component ($400 million) = $100 million.
Financing Fees
The $5 million in fees are deducted from the liability component. Net Liability = $400 million – $5 million = $395 million.
Balance Sheet Impact
Assets: Cash increases by $495 million (the $500 million proceeds net of the $5 million fee).
Liabilities: A liability for "Convertible Debt" is recorded at $395 million.
Equity: "Additional Paid-In Capital – Conversion Option" increases by $100 million.
Accounting for Early Retirement
If the same company decides to call the bond before maturity and before any conversion takes place, a different accounting treatment is required. The company must measure the present value of the liability component at the call date and compare it to its carrying amount on the books.
The difference is recorded as a gain or loss on the income statement. If the PV of the liability is less than its carrying amount, the company records a gain; if it is greater, a loss is recorded.
The company must then debit the liability component, debit any loss (or credit any gain), debit the equity component (to remove the value of the now-extinguished option), and credit cash for the amount paid to retire the bonds.
Key Drivers of a Convertible Bond's Price
The value of a convertible bond is fundamentally driven by two distinct parts: the value of a straight bond and the value of the embedded conversion option.
Value of Convertible = Value of Straight Bond + Value of Conversion Option
Several factors can influence these components and, therefore, the bond's overall market price.
Higher stock-price volatility increases the value of the embedded call option, making the entire convertible bond more valuable. This is consistent with the principles of option pricing models like Black-Scholes.
Conversely, a wide gap between the conversion price and the current stock price makes the bond less valuable, as the probability of a profitable conversion is low.
Lower risk-free interest rates or reduced stock volatility both diminish the value of the option component.
Less time to maturity shortens the life of the option, reducing the probability that the stock will exceed the conversion price and thus lowering the bond's value.
A common question arises when observing a convertible bond's payoff diagram: Why does its market value sometimes exceed its direct conversion value, even when the stock price is high? The answer lies in its downside protection. The bond holds a "bond floor," which is its value as a pure debt instrument. If the company's stock were to collapse, the bond would still return its principal at maturity, a guarantee that pure equity does not offer. This intrinsic protection makes the convertible bond inherently more valuable than the straight conversion value of its underlying shares.
From Debt to "Hedged Equity"
Not all convertible bonds are created equal. They exist on a spectrum, with some behaving more like traditional debt and others acting more like "hedged equity." The characteristics that push a convertible toward the equity end of the spectrum include:
1
A conversion strike price that is near or below the current share price, making the option "deep-in-the-money."
2
A very low or zero coupon, which minimizes the fixed-income payoff and emphasizes the equity component.
A payback period that exceeds the bond's maturity. The payback period measures the time it takes for the bond's yield to compensate the investor for the conversion premium paid. A very long payback period indicates that the investor's return is almost entirely dependent on stock price appreciation.
3
These differing profiles appeal to different types of investors. Consider two 5-year convertible bonds:
Bond A (Payback Period of 3 years): This bond would appeal to fixed-income investors. Its shorter payback period allows for a quicker recovery of the premium, signaling lower equity risk and a greater emphasis on yield.
Bond B (Payback Period of 25 years): This bond is more suited for equity-oriented or hedge-style investors. The long payback period implies the investor is forgoing yield in favor of long-term upside potential from the stock, using the bond's structure primarily for its downside protection.
Strategic Considerations for Issuers: Managing Shareholder Dilution
While convertibles offer issuers benefits like lower coupons, their primary drawback is the potential for diluting the ownership of existing shareholders upon conversion. To mitigate this, companies can employ a hedging strategy known as a call-spread overlay.
This typically involves two simultaneous transactions: (1) The company buys call options on its own stock with a strike price equal to the bond's conversion price; (2) The company sells warrants (another type of call option) on its stock at a higher strike price.
The net effect is that the company is hedged against dilution for any stock price appreciation between the conversion price and the higher warrant strike price. This effectively raises the conversion price, limiting the number of new shares that need to be issued. However, this protection comes at a cost, as the net premium paid for the call spread can be substantial and must be weighed against the company's overall cost of capital.