What it means
A convertible security is only meaningful once you know how many shares it turns into. The conversion ratio answers that question directly, telling the holder that one bond becomes a specific number of shares regardless of what the market is doing at the time.
Because the ratio is fixed and the share price is not, the value of the conversion right moves entirely with the equity. Twenty-five shares are worth $750 when the shares are at $30 and $1,250 when they reach $50, while the bond's face value stays at $1,000 throughout.
The ratio is the quickest way to work out the break-even share price, sometimes called the parity price. Divide the market price of the bond by the conversion ratio and you get the share price at which converting exactly matches selling the bond.
Conversion ratios are adjusted for corporate actions so holders are not disadvantaged by events they did not choose. A two for one share split doubles the ratio, a bonus issue increases it proportionally, and a special dividend usually triggers a formula-based increase written into the terms.
Ratios also appear on preference shares and on convertible loan notes used in private funding rounds. The arithmetic is identical, though private deals often express the same idea as a discount to a future funding round price rather than a fixed number of shares.
In practice
Real-world examples
Example 1
A pension fund holds 500 convertible bonds with a ratio of 25 shares each. Because the ratio is fixed, the fund knows it is holding an exposure to 500 x 25 = 12,500 shares and can hedge that position precisely in the equity market.
Example 2
A brewery carries out a three for one share split. Its convertible's ratio rises automatically from 20 to 60 shares per bond, and the conversion price falls from $50 to $16.67, leaving bondholders exactly where they were.
Example 3
A private company issues convertible loan notes to angel investors. Rather than a fixed ratio, the notes convert at a 20% discount to the next priced round, so the effective ratio is only settled when that round closes.
Think of it
Think of a conversion ratio like a fixed exchange rate at an airport kiosk, but instead of trading pounds for euros, you are trading a loan voucher for slices of company ownership.
Formula
Calculation
Conversion ratio = Face value of the security / Conversion price. The parity share price is then Market price of the convertible / Conversion ratio.
A media company issues convertible bonds with a face value of $1,000 and a conversion price of $40 per share.
Conversion ratio = $1,000 / $40 = 25 shares per bond.
Some months later the bond trades at $1,100 in the market. The parity price is $1,100 / 25 = $44 per share, which means an investor buying the bond at $1,100 today is paying the equivalent of $44 for each underlying share. If the shares are trading at $38, the investor is paying a premium of $44 - $38 = $6 per share, or $6 / $38 = 15.8% above the market price, in return for the bond's income and its protection on the downside.Case study
Seen in the real world
The following is a fictional, illustrative example. Larkspur Media Group, an invented broadcaster, issued convertible bonds with a conversion ratio of 25 shares per $1,000 bond. Two years later the board approved a large special dividend to return cash from a disposal, and the treasury team failed to check the bond terms first.
The bond documentation contained a standard adjustment clause requiring the conversion ratio to be increased whenever a dividend exceeded a set threshold. The ratio rose from 25 to 27 shares per bond, and on a $60,000,000 issue that meant an extra 2 x 60,000 = 120,000 shares would be created on full conversion, on top of the 1,500,000 already expected.
Larkspur's board still went ahead with the dividend, but the episode changed its process. In this fictional case, every distribution proposal now carries a note showing the effect on outstanding convertible ratios before it goes to a vote.
Watch out
Common mistakes
- Treating the conversion ratio as the same thing as the conversion price. The ratio is a share count and the price is a dollar figure per share; they are two views of the same term, linked by the face value.
- Assuming the ratio is fixed for the life of the bond. Splits, bonus issues and large special dividends normally trigger adjustments written into the terms, all of which increase the number of shares per bond.
- Multiplying the ratio by the bond's market price instead of the share price. Conversion value is the ratio times the share price, and mixing the two produces a figure that means nothing.
Questions
People also ask
How do I work out the parity share price?
Divide the current market price of the convertible by the conversion ratio; that is the effective price per share you are paying by buying the bond.
Does a higher conversion ratio always favour the holder?
Yes on its own, since more shares per bond is more value, but issuers normally pair a generous ratio with a lower coupon or tighter call terms.
Where is the conversion ratio actually stated?
It appears in the bond indenture or the terms of issue, and listed issuers usually restate it in the notes to the financial statements each year.