What it means
A company that wants to borrow at a low rate and an investor who wants a bond with upside can meet in a convertible. The bond pays, say, 2% when the company's straight debt would cost 6%; in exchange, the holder can convert each $1,000 bond into 40 shares (a conversion price of $25) at any time before maturity.
If the shares are trading at $20 at issue, the holder has paid for an option that is out of the money by 25% (the conversion premium). If the shares rise to $40, the bond is worth at least $1,600 through conversion; if they stay at $20, the holder keeps the 2% coupon and gets $1,000 back at maturity, having earned less than a straight bond would have paid.
The instrument's value is therefore the sum of a bond and an option, and its price behaves accordingly: when the shares are far below the conversion price, the convertible trades like a bond (its value floor is the bond value); when far above, it trades like the shares (its value is conversion value); in between, it trades above both, reflecting the option's time value. The key terms are the conversion ratio (shares per bond), the conversion price (face value divided by the ratio), the conversion premium at issue (the excess of the conversion price over the share price), the coupon, the maturity, and any call provisions (the issuer can usually force early redemption once the shares trade above a threshold, which in practice forces conversion) and put provisions (the holder can require early repayment).
For the issuer, the advantages are a lower cash interest cost than straight debt, the deferral of dilution (shares are issued only on conversion, and at a premium to the price at issue), the possibility that the debt never has to be repaid in cash, and access to investors who would not buy the company's straight debt or its shares alone. The disadvantages are dilution if the shares rise (the company issues shares at $25 that are worth $40), the debt overhang if they do not (the bond must be repaid, and the company has paid a low coupon for an option that expired worthless to the investor but was real to the company), and complexity in accounting and in communicating with equity investors who dislike the dilution risk.
Accounting under IFRS (IAS 32) treats a convertible with a fixed conversion ratio as a compound instrument: at issue, the fair value of the liability component is measured as the present value of the coupons and principal at the rate for equivalent non-convertible debt, and the remainder of the proceeds is the equity component, recognised in equity and never remeasured. The liability accretes to face value over the bond's life at the effective rate, so interest expense is the market rate for straight debt, not the coupon.
On conversion, the liability and equity components are transferred to share capital and premium; on redemption, the liability is settled and the equity component stays in equity. Where the conversion terms are not fixed (a variable number of shares, or a conversion price in a different currency), the conversion feature is a derivative liability remeasured through profit.
US GAAP has moved to a simpler model in which most convertibles are accounted for as a single liability at amortised cost, with the conversion feature not separated unless it is a derivative. For readers, a convertible's presence means: reported interest exceeds cash interest; diluted earnings per share must assume conversion (the if-converted method); and the balance sheet shows a liability that may become equity, or equity that may need to be repaid as debt, depending on the share price.
In practice
Real-world examples.
Example
A biotech company with no straight-debt market issues a 1% convertible at a 35% premium, funding trials with investors who want equity exposure with downside protection.
Example
A utility issues a 3% convertible at a 20% premium and, when its shares rise, calls the bonds, converting $500 million of debt to equity and cutting its leverage.
Example
A distressed retailer's lenders convert their loans into convertible notes in a restructuring, taking a low coupon now for a share of any recovery.
Think of it
“A convertible bond is a bond that can become stock-debt with an option to convert to ownership.
Formula
Calculation
Conversion Ratio = Face value / Conversion price
Conversion Value = Conversion ratio x Current share price
Conversion Premium (at issue) = (Conversion price minus Share price) / Share price x 100%
Bond Floor = Present value of coupons and principal at the straight-debt yield
Liability component (IFRS, at issue) = Bond floor at issue; Equity component = Proceeds minus Liability component
Effective interest = Liability component x Straight-debt rate (accreting each year)
Worked example. A technology company issues $50,000,000 of five-year convertible bonds at par with a 2.5% annual coupon, convertible at $40 a share (conversion ratio 25 shares per $1,000 bond). The share price at issue is $32 (conversion premium 25%). The company's straight five-year debt would yield 7%.
Investor's view:
- Bond floor = present value of $25 a year for five years plus $1,000 at 7% = $25 x 4.100 + $1,000 x 0.713 = $102.50 + $713 = $815.50 per bond
- Conversion value at issue = 25 x $32 = $800
- The bond's $1,000 price exceeds both: the $184.50 above the bond floor is the price of the option
- If the shares reach $60 in year 4: conversion value $1,500; the holder converts (or sells the bond at about that price), a 50% gain plus coupons
- If the shares stay at $32: the holder receives $25 a year and $1,000 at maturity; total return 2.5% a year, against 7% on straight debt: the cost of the option that did not pay
Issuer's accounting (IFRS):
- Liability component at issue = $815.50 x 50,000 bonds = $40,775,000
- Equity component = $50,000,000 minus $40,775,000 = $9,225,000, credited to equity (a conversion option reserve)
- Year 1 interest expense = $40,775,000 x 7% = $2,854,000; cash coupon $1,250,000; accretion $1,604,000; liability at end of year 1 $42,379,000
- Year 2: interest $2,967,000; coupon $1,250,000; accretion $1,717,000; liability $44,096,000
- Years 3 to 5 continue; at maturity the liability reaches $50,000,000
- Reported interest over five years: about $15,480,000 against cash coupons of $6,250,000. The $9,230,000 difference (the equity component, with rounding) is the cost of the conversion option, charged through profit as interest
Conversion scenario: in year 4, with the shares at $60, the issuer calls the bonds (the terms allow a call when the shares exceed $52 for 20 days) and all holders convert. Shares issued: 1,250,000 at $40 (the conversion price), when the market price is $60: dilution cost to existing shareholders of $25,000,000 in value transferred. The liability (about $47,900,000 at that point) and the equity component ($9,225,000) are transferred to share capital and share premium. The company has raised $50,000,000 for four years at a cash cost of 2.5% and issued shares at $40 that it could have sold at $60 had it waited; whether that was a good deal depends on what the money achieved in the meantime.
Redemption scenario: the shares never exceed $40; at maturity the company repays $50,000,000. It has borrowed at an effective 7% in reported terms and 2.5% in cash terms; the equity component of $9,225,000 stays in equity as a permanent record of an option that expired. It has had to refinance $50,000,000 of debt that it may have hoped would convert.
Diluted EPS: net income $12,000,000; shares 20,000,000; basic EPS $0.60. If-converted: add back after-tax interest on the convertible ($2,854,000 x 0.75 = $2,140,000) and add 1,250,000 shares: diluted EPS = $14,140,000 / 21,250,000 = $0.665. Since this exceeds basic EPS, the convertible is anti-dilutive this year and diluted EPS is reported as $0.60; as the company's earnings grow, it will become dilutive.Case study
Seen in the real world.
A software company with a share price of $18 and a strong growth story issued $120,000,000 of five-year convertibles at a 1.5% coupon and a $24 conversion price, saving about $6,000,000 a year of cash interest against straight debt. Its equity analysts objected mildly to the potential dilution of 5,000,000 shares (10% of the company) but accepted the logic. Three years later the share price was $11 after two product delays; the bonds traded at 78 cents in the dollar as a distressed credit, the conversion option was worthless, and the company faced repaying $120,000,000 in two years from cash flow that had not developed as planned.
It refinanced with a new convertible at a 6% coupon and a $13 conversion price, offering existing holders an exchange at a premium to their bonds' market value; the new terms implied dilution of nearly 9,000,000 shares if the company recovered, and a 6% cash cost if it did not. The finance director's later assessment was that the original issue had been priced on the assumption that the shares would rise, that the company had in effect sold its shareholders' upside cheaply and kept the debt, and that a smaller straight-debt facility with a shorter maturity would have been more expensive in interest and far cheaper in consequences.
Watch out
Common mistakes.
- Treating the coupon as the cost of a convertible. The true cost includes the option given away, which accounting reports as the effective interest rate and which materialises as dilution on conversion.
- Assuming conversion will happen. If the shares do not rise, the convertible is debt that must be repaid, often at a time when the company's position has weakened.
- Ignoring the call and put provisions, which determine when the issuer can force conversion and when the holder can demand repayment.
Questions
People also ask.
Why would an investor accept a lower coupon?
For the conversion option: the right to share in the equity's rise while holding a bond's downside protection. The coupon discount is the option's price.
How does a convertible affect earnings per share?
Basic EPS is unaffected until conversion. Diluted EPS assumes conversion (adding back the after-tax interest and adding the shares) when the effect is dilutive.
What happens to the equity component if the bond is redeemed rather than converted?
Under IFRS it remains in equity, typically transferred to retained earnings; it is not reversed through profit. The company's shareholders have effectively received a payment for an option that expired.
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