What it means
A convertible bond lets the holder swap it for a fixed number of shares. Holders normally wait, because the bond pays interest while still capturing any rise in the share price, so they enjoy the upside without giving up the safety.
Issuers do not always want to wait. A call provision lets the company redeem the bond early at a set price, and once the shares are worth more than that price, holders convert rather than take the cash.
The company's motive is usually the balance sheet. Conversion removes debt, stops the interest payments and strengthens the equity base, all without needing to find cash to repay the borrowing.
There is typically a trigger condition written into the terms. A common one requires the share price to trade above 130% of the conversion price for a set number of days before the issuer may call, which protects holders from being called out at an unfavourable moment.
For shareholders the effect is dilution arriving on the issuer's timetable. New shares appear, earnings per share fall, and although the debt disappears, the existing owners have handed over a slice of the company to achieve it.
Convertible preferred shares work the same way. The issuer calls the preferred, holders convert to ordinary shares to capture the higher value, and the company simplifies its capital structure in a single step.
In practice
Real-world examples.
Example
A biotech that funded trials with convertible bonds sees its share price triple after a successful result. It calls the bonds, holders convert, and $40,000,000 of debt becomes equity without a dollar of cash leaving the business.
Example
A property developer forces conversion of its convertible preferred shares to meet a loan covenant requiring a higher equity ratio. The bank is satisfied, but ordinary shareholders see their stake diluted by 12%.
Example
A holder of $500,000 of convertible bonds receives a call notice with two weeks to respond. Converting yields shares worth $610,000 against a $515,000 call price, so the choice takes about ten seconds.
Formula
Calculation
Conversion price = Par value / Conversion ratio
Conversion value = Conversion ratio x Current share price
Holders convert when Conversion value is greater than Call price
A technology company issued 20,000 convertible bonds, each with a par value of $1,000, a 5% coupon and a conversion ratio of 25 shares per bond.
Conversion price = $1,000 / 25 = $40 per share
Call trigger at 130% = $40 x 1.30 = $52 per share
The shares reach $52 and stay there, so the company calls the bonds at $1,030 each.
Conversion value = 25 shares x $52 = $1,300
Call price = $1,030
Every rational holder converts, because $1,300 of shares beats $1,030 of cash by $270 per bond. Across the issue, the company retires $20,000,000 of debt, issues 20,000 x 25 = 500,000 new shares, and saves $20,000,000 x 5% = $1,000,000 of interest a year.Case study
Seen in the real world.
Kelbrook Robotics is a fictional company invented to illustrate forced conversion. Two years earlier it had raised $30,000,000 through convertible bonds carrying a 6% coupon and a conversion price of $25, at a time when its shares traded near $18 and a straight loan would have been far more expensive.
After a major contract win the shares climbed past $34 and held there. With the 130% trigger of $32.50 comfortably cleared, the board called the bonds at $1,020 per $1,000 of par. Conversion value was 40 shares at $34, or $1,360, so effectively every holder converted, wiping out $30,000,000 of debt and saving $1,800,000 of annual interest.
The illustrative catch is that Kelbrook's founders went from holding 58% of the company to 46%. The board considered it a fair exchange for a debt-free balance sheet ahead of a larger funding round, but it is a reminder that forced conversion trades cash obligations for permanent ownership.
Watch out
Common mistakes.
- Thinking holders are legally compelled to convert. They may always take the call price instead, but when the shares are worth far more, taking cash would simply be a poor decision.
- Reading forced conversion as bad news for the company. It usually signals the share price has risen well above the conversion price, which is the outcome the issuer hoped for.
- Overlooking the dilution. Debt disappearing from the balance sheet is visible, but the new shares reduce earnings per share and every existing holder's percentage.
Questions
People also ask.
Why would a company force conversion?
To remove debt and interest payments from the balance sheet without spending cash, and to strengthen equity ahead of further borrowing or a new raise.
What is a soft call provision?
It is a call right the issuer may only use once the share price has traded above a stated threshold, commonly 130% of the conversion price, for a set number of days.
What happens if the share price falls before the deadline?
If the conversion value drops below the call price, holders will take the cash instead, which leaves the company having to fund the redemption.
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