An Introduction to Convertible Bonds (Part II)
In the second and final instalment of our convertible bonds series, we explore some of the factors that investors may wish to consider before investing.
Conversion price
The conversion price is established when the convertible bond is issued and is the price to be paid per share to acquire the common stock of the issuer. This is usually set at a higher price then what the stock is trading at on the market at the time the convertible bond is issued. For example, the common stock of XYZ Inc. is trading at $35 and the conversion price is set at $50. If the investor decides to convert and trade in the convertible bond, he would have to pay $50 a share for XYZ Inc.s common stock.
Conversion Ratio
This ratio determines the number of shares of common stock the convertible bond can be exchanged for when the bond is converted. Conversion Ratio = Par value of the convertible bond / Conversion Price = $1,000 / $50 = 20 If the par value of the convertible bond is $1,000 and the conversion price is $50, the investor will receive 20 shares of common stock for each bond they exchange.
Parity
This is a convertible bonds theoretical value if it were a straight bond without the conversion option. Simply put, it is the point where there is no gain or loss made at conversion. Parity = Current price of common stock x Conversion Ratio = $35 x 20 = $700
Conversion premium
The conversion premium is simply the difference between the current market price of the convertible bond and the current market value of the common stock into which it may be converted (parity). For example, if the current market price of the convertible bond is $950 and parity is $700, the conversion premium would be 26%. Conversion Premium = (Current price of Convertible Bond - Parity) / Current price of Convertible Bond = ($950 - $700) / $950 = $250 / $950 = 0.26 or 26% As investors take advantage of both traditional and non-traditional investments to achieve their financial objectives, they are encouraged to consider the complete picture of all their investments in their portfolio, and should always keep in mind their investment objectives, time horizons, and risk appetites when making investment decisions.
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