What it means
At its simplest, a convertible security is a loan with an option attached. The investor lends money and collects a coupon, but keeps the right to swap the loan for shares at a price agreed on day one.
If the shares never reach that price, the investor simply keeps collecting interest and gets the principal back at maturity. Companies issue convertibles because that conversion right is worth money to investors, and investors pay for it by accepting a lower coupon.
A business that would pay 9% on a straight bond might pay 4% on a convertible whose conversion price sits 25% above today's share price. The cost is dilution: if the shares do climb and holders convert, new shares are issued and existing owners end up with a smaller slice of the company.
Three numbers do most of the work here: the conversion price, the conversion ratio and the conversion premium. The ratio tells you how many shares each unit turns into, and the premium tells you how far the shares must rise before converting beats holding the bond.
Analysts also track the investment value, which is what the security would be worth as pure debt if the conversion right were stripped away. Convertible preferred shares behave the same way but sit in the equity section of the balance sheet, which matters to lenders looking at gearing and covenants.
Early-stage companies use a close cousin, the convertible note, to raise money quickly without having to agree a valuation upfront. These notes usually carry a discount or a valuation cap so that early money converts on better terms than the next funding round.
Accounting treatment varies by instrument and by jurisdiction, and it can change the headline earnings figure. Companies generally have to report diluted earnings per share as though conversion had already happened, so a convertible can weigh on that number long before a single new share is issued.
In practice
Real-world examples.
Example
A software company issues $40,000,000 of five-year convertible bonds at a 3.5% coupon when straight debt would have cost roughly 8%. The lower coupon saves $1,800,000 of interest a year, which the finance director redirects into hiring engineers. In return, holders may convert into shares priced 30% above the current level.
Example
A family-owned manufacturer sells $2,000,000 of convertible preferred shares to a private investor at a 6% dividend, which is $120,000 a year. The preferred converts into 100,000 ordinary shares at $20 each. The founders keep voting control unless the investor converts, which only makes sense if the business is eventually sold at a good price.
Example
A seed-stage marketplace raises $750,000 on a convertible note with a 20% discount and a $6,000,000 valuation cap. When the company later raises a priced round at a $10,000,000 valuation, the discount would give an $8,000,000 conversion price, but the lower $6,000,000 cap applies instead. The note holders therefore convert on the more generous of the two terms.
Formula
Calculation
Conversion ratio = Par value / Conversion price. Conversion value = Conversion ratio x Current share price. Conversion premium = Market price of the convertible - Conversion value.
A company issues a convertible bond with a par value of $1,000 and a conversion price of $25 per share. The conversion ratio is $1,000 / $25 = 40 shares per bond. The shares currently trade at $22, so the conversion value is 40 x $22 = $880. The bond itself trades at $1,056, so the conversion premium is $1,056 - $880 = $176, which is $176 / $880 = 20% above conversion value. Put another way, the break-even share price is $1,056 / 40 = $26.40, so the shares must rise 20% from $22 before converting is worth doing.Case study
Seen in the real world.
Larkspur Diagnostics is an illustrative, entirely fictional medical device maker with 20,000,000 shares outstanding trading at $20. Needing $60,000,000 to build a second production line, its board is quoted 9% on a straight bond, an interest bill of $5,400,000 a year that would have breached a covenant with its existing lender. Instead the company issues $60,000,000 of convertible bonds with a 4% coupon and a $25 conversion price, a 25% premium to the current share price.
The lower coupon costs $2,400,000 a year, saving $3,000,000 of interest compared with the straight bond. Two years later the new line is running and the shares reach $38, so each $1,000 bond has a conversion value of 40 x $38 = $1,520 and holders convert. Larkspur issues 60,000 bonds x 40 shares = 2,400,000 new shares, and the debt disappears from the balance sheet.
The existing owners now hold 20,000,000 of 22,400,000 shares, so they have been diluted by 10.7%. In this fictional case the board judged that trade worthwhile, because the alternative was either an expensive bond that breached a covenant or an equity raise at $20 rather than an effective $25.
Watch out
Common mistakes.
- Treating the low coupon as free money. The cheap interest is paid for with an option on the company's own shares, and that option can prove far more expensive than the interest saved.
- Ignoring convertibles when working out ownership percentages. Founders often calculate their stake on shares outstanding today and get an unpleasant surprise when notes and convertible preferred all convert at once.
- Assuming conversion is automatic at maturity. Conversion is usually the holder's choice, and if the shares are below the conversion price the holder will simply take the cash instead.
Questions
People also ask.
What happens if the share price never reaches the conversion price?
The security behaves like an ordinary bond or preferred share, paying its coupon until maturity and then repaying principal, and the conversion right expires unused.
Are convertibles debt or equity on the balance sheet?
Convertible bonds normally start life as debt and convertible preferred sits in equity, though accounting standards may require the option element to be separated and valued.
Why do investors accept a lower yield on a convertible?
Because they are buying downside protection from the bond floor plus upside participation from the shares, a combination they cannot get from either instrument alone.
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