What it means
When a company issues a convertible bond it has to answer one central question: how many shares will each bond turn into? Rather than quote a share count directly, issuers usually quote a conversion price, from which the share count follows automatically.
The conversion price is almost always set at a premium to the share price on the day of issue. A company whose shares trade at $32 might set a conversion price of $40, meaning the shares must rise by a quarter before conversion is worth anything to the holder.
That premium is the lever the issuer pulls to balance cost against dilution. A high conversion price means fewer shares are created if conversion happens, but investors will demand a higher coupon to compensate for a right that is harder to use.
The conversion price is not always frozen forever. Standard anti-dilution clauses reduce it after share splits, bonus issues or discounted rights issues, so the holder's economic position is not damaged by corporate actions that increase the share count.
Some convertibles use a variable conversion price linked to the share price at the time of conversion, most often in smaller or distressed issuers. These structures are far more dangerous for existing shareholders, because a falling share price mechanically creates more and more new shares.
In practice
Real-world examples
Example 1
A renewable energy developer sets a conversion price of $18 when its shares trade at $12. Four years later the shares reach $26, holders convert, and the developer clears $60,000,000 of debt from its balance sheet without a cash repayment.
Example 2
A listed retailer carries out a two for one share split, so its convertible's conversion price is automatically halved from $50 to $25 and the conversion ratio doubles. Bondholders end up with exactly the same economic claim as before the split.
Example 3
A small mining company issues convertible notes with a conversion price reset each quarter to 85% of the prevailing share price. The share price falls steadily, each reset creates more shares, and existing shareholders find their stake shrinking without a single new dollar coming in.
Think of it
Imagine buying a voucher for a bakery that lets you swap a ten-pound gift card for loaves of bread at a locked-in price of one pound each, no matter how much bread prices rise later.
Formula
Calculation
Conversion price = Face value of the security / Conversion ratio. Working the other way, Conversion ratio = Face value / Conversion price.
A consumer goods company plans a $10,000,000 convertible bond issue with a face value of $1,000 per bond, so there will be $10,000,000 / $1,000 = 10,000 bonds. Its shares currently trade at $32 and the bank advises an initial conversion premium of 25%.
Conversion price = $32 x 1.25 = $40 per share.
Conversion ratio = $1,000 / $40 = 25 shares per bond. If every bond converts, the company issues 10,000 x 25 = 250,000 new shares. With 2,000,000 shares already outstanding, the share count would rise to 2,250,000, so existing holders would own 2,000,000 / 2,250,000 = 88.9% of the enlarged company and give up 11.1% to the converting bondholders.Case study
Seen in the real world
This is an illustrative, fictional case. Fernhill Instruments, an invented scientific equipment maker, needed $20,000,000 and chose a convertible with a conversion price of $50 against a share price of $40, giving a 25% premium and a 2.5% coupon. The board considered a conversion price of $60 that would have created fewer shares, but investors wanted a 4% coupon in return.
Fernhill chose the lower conversion price and saved 1.5% a year on a $20,000,000 issue, which is $300,000 of cash interest annually. Over the five-year term that saving totalled $1,500,000, set against issuing 400,000 shares at $50 rather than 333,333 shares at $60 if conversion happened.
The chief financial officer presented both routes to the board as a straight trade of cash today against ownership tomorrow. In this fictional example the decision was defensible either way, and what mattered was that the board understood it was making an equity decision, not a debt one.
Watch out
Common mistakes
- Confusing the conversion price with the price paid for the bond. The conversion price is the notional cost per share on conversion, not the market price of the convertible security itself.
- Assuming the conversion price never changes. Anti-dilution clauses adjust it for splits, bonus issues and discounted rights issues, and some structures reset it periodically against the market price.
- Setting a very high conversion price to protect against dilution without pricing the consequence. A conversion right that is hard to use forces investors to demand a higher coupon, so the saving in shares is paid for in cash interest.
Questions
People also ask
How is the initial conversion price chosen?
It is usually set at a premium of roughly 20% to 40% over the share price on the day of issue, with the exact level negotiated against the coupon.
What happens if the share price never reaches the conversion price?
The holder simply keeps collecting coupons and is repaid the face value at maturity, and no new shares are ever created.
Is a lower conversion price better for investors?
Yes in isolation, because it produces more shares per bond, but issuers will normally offset a lower conversion price with a lower coupon.