What it means
A convertible security is really two things stapled together: an ordinary bond and an option over the issuer's shares. The bond part promises interest and repayment; the option part gives the holder the right, but never the obligation, to swap the bond for shares.
Because the option is valuable, investors are willing to accept a lower coupon than they would demand on plain debt. The company is effectively paying for the borrowing partly in cash interest and partly by giving away potential shares, which is cheaper day to day but costlier if the share price soars.
The value of the conversion option rises with the share price, with the volatility of the shares, and with the time left before the bond matures. A young, fast-moving company with a jumpy share price gives away more value in the option than a stable utility would, which is exactly why convertibles are popular with growth businesses.
Analysts value a convertible by splitting it in two: work out what the bond would be worth as plain debt at the issuer's normal borrowing rate, then treat the rest of the market price as the value of the conversion option. That split matters for accounting too, since many standards require the debt and equity elements to be recorded separately at issue.
A conversion option is not always a clean, simple right. Terms can include a hard call that forces conversion, a soft call that requires the share price to hold above a level for a set number of days, or an anti-dilution clause that adjusts the ratio after a rights issue.
In practice
Real-world examples
Example 1
A biotechnology firm with no profits and a volatile share price issues convertibles at 1%. Investors accept the token coupon because the conversion option on such a jumpy share is worth a great deal, and the firm preserves cash during its trial phase.
Example 2
A regional water utility tries the same trick and finds the pricing far less generous. Its share price barely moves from year to year, so the conversion option is worth little and investors demand a coupon close to what plain debt would cost.
Example 3
An acquirer reviewing a target's balance sheet spots convertible notes whose conversion option is deep in the money. It adds the shares those notes would create to the purchase price calculation, raising the effective cost of the deal by several percentage points.
Think of it
Imagine buying a cinema ticket that lets you pay a standard entry price, but with a special voucher attached. If the movie turns out to be a massive blockbuster and tickets for the sequel become collectors items, you can use your voucher to trade your cinema seat for a share in the film studio. If the movie is boring, you just watch the show and go home.
Formula
Calculation
Value of the conversion option = Market price of the convertible - Straight bond value. The straight bond value is what the same cash flows would be worth if the security had no conversion right.
A technology company issues a five-year convertible bond at par of $1,000 with a 2% annual coupon, so it pays $20 a year and $1,000 at maturity. If the company issued ordinary debt of the same maturity, investors would demand 7%.
Discounting at 7%, the five-year annuity factor is 4.1002, so the coupons are worth $20 x 4.1002 = $82. The principal is worth $1,000 / 1.07 raised to the power of five, which is $1,000 x 0.71299 = $713. The straight bond value is therefore $82 + $713 = $795.
The convertible was issued at $1,000, so the conversion option is worth $1,000 - $795 = $205 per bond, or 20.5% of the issue price. On a $50,000,000 issue that is 50,000 bonds x $205 = $10,250,000 of value the company has handed over in return for paying 2% instead of 7%.Case study
Seen in the real world
The following is an illustrative and entirely fictional example. Vantage Robotics, an invented automation company, issued $40,000,000 of five-year convertibles at a 1.5% coupon when its shares traded at $30, with a conversion price of $45. The board celebrated the low cash cost and recorded the whole issue as debt in its internal reporting pack.
The auditors later required the issue to be split, with the straight bond value recorded as a liability and the conversion option recorded within equity. That split changed reported interest expense, because the discount on the debt component had to be amortised over the life of the bond, and Vantage's finance team had to restate its own internal forecasts.
The wider lesson from this fictional case is that a conversion option is never free. Vantage paid for its cheap coupon with a slice of future ownership, and the accounting simply made that price visible in the numbers.
Watch out
Common mistakes
- Treating a convertible as ordinary debt because the coupon looks like interest. The conversion option is a separate piece of value that belongs to shareholders, and ignoring it understates the true cost of the borrowing.
- Assuming the conversion option is worthless while the share price sits below the conversion price. Time and volatility give the option value long before the shares reach the trigger level, which is why out-of-the-money convertibles still trade above their plain bond value.
- Forgetting that the issuer can often take the option back. Soft call clauses let the company force conversion once the share price holds above a threshold, capping the upside the holder was counting on.
Questions
People also ask
How is the value of a conversion option estimated?
Most analysts either subtract the straight bond value from the market price or run an option pricing model using the share price, volatility, time to maturity and conversion price.
Does the conversion option expire?
Yes, it usually runs to the bond's maturity or to an earlier date set in the terms, after which the holder simply receives cash repayment.
Why do companies give away a conversion option at all?
Because it cuts the cash coupon sharply, which suits businesses that need to preserve cash now and are comfortable issuing shares later if things go well.