What it means
Every convertible bond has a conversion value, which is simply the number of shares it converts into multiplied by the current share price. In practice the bond almost always trades above that figure, and the excess is the conversion premium.
Investors pay the premium because the bond still gives them income and repayment of principal even if the shares fall. That downside protection is worth something, and so is the remaining time before maturity during which the shares might rise a great deal.
The size of the premium tells you something about market expectations. A wide premium usually means investors expect the share price to move a lot, while a premium close to zero suggests the bond is behaving almost exactly like the shares themselves.
Premiums shrink as the share price climbs. When a convertible is deep in the money the bond floor becomes irrelevant, the security tracks the equity almost one for one, and there is little reason to pay extra for protection that is no longer doing any work.
A useful companion measure is the premium recovery period, which asks how many years of extra income from the bond it would take to earn back the premium paid. If the answer is longer than the time left to maturity, the premium is hard to justify on income grounds alone.
In practice
Real-world examples.
Example
A fund manager compares two convertibles from similar retailers. One carries a 9% premium and the other 28%, so the first behaves much more like the underlying equity while the second offers far more downside cushion for anyone nervous about the sector.
Example
A treasury team pricing a new convertible issue sets the terms to give an initial conversion premium of 30% over the current share price. That premium is what lets the company cut the coupon from 6% to 2.25%, since investors are effectively buying a longer-dated option.
Example
An industrial group's shares triple after a contract win, and its outstanding convertible sees its premium collapse from 22% to under 2%. Holders now watch the equity rather than the bond market, because the security has become a near substitute for the shares.
Formula
Calculation
Conversion premium = Market price of the convertible - Conversion value, where Conversion value = Conversion ratio x Current share price. Conversion premium % = Conversion premium / Conversion value.
A convertible bond with a face value of $1,000 has a conversion ratio of 40 shares. The company's shares trade at $25, so the conversion value is 40 x $25 = $1,000. The bond itself trades in the market at $1,150.
Conversion premium = $1,150 - $1,000 = $150 per bond. As a percentage that is $150 / $1,000 = 15%.
To test whether the premium is reasonable, look at the income. The bond pays a 4.5% coupon, or $45 a year, while 40 shares paying a $0.30 annual dividend would deliver 40 x $0.30 = $12. The income advantage is $45 - $12 = $33 a year. Expressed per share that is $33 / 40 = $0.825, and the premium per share is $150 / 40 = $3.75. The premium recovery period is therefore $3.75 / $0.825 = 4.5 years, which is comfortable if the bond has seven years left and poor if it has two.Case study
Seen in the real world.
This case is illustrative and the company is fictional. Bramley Coastal Freight, an invented shipping operator, issued convertibles with a 25% conversion premium at a 2% coupon while its shares traded at $16 and the conversion price was set at $20. Retail investors bought heavily on the view that the bonds were a cheap way to own the equity.
Freight rates then flattened and the shares drifted to $13. The conversion premium widened above 50% simply because the conversion value had fallen while the bond floor held the price up, and several holders concluded, wrongly, that the bonds had become expensive. In fact the premium had widened because the protection they had paid for was doing precisely what it was meant to do.
The finance team started publishing both the conversion value and the straight bond value alongside the market price in its investor updates. The point of this fictional example is that a rising premium is not automatically bad news; it often just means the bond floor has taken over.
Watch out
Common mistakes.
- Reading a high conversion premium as a sign the bond is overpriced. A premium can widen simply because the share price fell and the bond floor is now supporting the price, which is protection working as intended.
- Quoting the premium in dollars without saying what it is a percentage of. A $150 premium means something very different on a conversion value of $1,000 than on one of $3,000, so always state the basis.
- Ignoring the coupon when judging whether a premium is fair. The extra income a convertible pays over the dividends on the underlying shares is what pays the premium back over time.
Questions
People also ask.
What is a typical initial conversion premium on a new issue?
It commonly ranges from around 20% to 40% above the share price at issue, depending on how volatile the shares are and how strong demand is.
Does the premium ever go negative?
Very rarely and only briefly, because a convertible trading below its conversion value would let an arbitrageur buy the bond, convert, and sell the shares for an immediate profit.
Is a low premium good or bad?
Neither on its own; it simply means the security is tracking the shares closely and offering little cushion, which suits an equity investor and disappoints a cautious one.
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