What it means
A convertible bond gives the holder the option to swap the bond for shares at a fixed ratio. A zero-coupon version pays no periodic interest, so the issuer saves cash during the life of the bond.
The investor's return comes from the discount to face value and from the conversion option. Issuers like these bonds because they lower cash interest costs and, if the shares rise, the bond converts into equity rather than needing repayment.
Younger growth companies often use them because their cash is better spent on growth than on interest. The cost is dilution, meaning existing shareholders own a smaller share of the company after conversion.
Investors like them because they have a floor and a potential upside. If the shares fall, the bond still repays its face value at maturity, which protects capital as long as the issuer is solvent.
If the shares rise strongly, converting delivers a share of the gain. The key figures are the conversion ratio, the number of shares received per bond, and the conversion price, which is the bond's price divided by that ratio.
The conversion premium compares the bond's price with the value of the shares it would turn into. Many zero-coupon convertibles also let the holder sell the bond back to the issuer at set dates, which adds protection.
The nuance is that accounting and tax treatment can be complicated. The issuer may have to record non-cash interest expense each period as the discount unwinds, even though no cash is paid.
Credit risk also matters, since the investor depends on the issuer to repay if the shares do not rise. For valuation, analysts split the instrument into two parts, a straight bond and an embedded option.
The bond part is worth the present value of the face amount, and the option part is worth whatever the market will pay for the right to convert. Comparing the two parts shows how much of the price is protection and how much is hope.
In practice
Real-world examples.
Example
A biotech company issues $100,000,000 of zero-coupon convertibles to fund clinical trials. Because it pays no interest, it keeps its cash for research. If the drug succeeds and the shares rise, the bonds convert and the company never repays the cash.
Example
A hedge fund buys a zero-coupon convertible and sells short the shares it can convert into. It profits from share price moves in either direction. It also collects the discount on the bond as the maturity date approaches.
Example
A life insurer buys convertible bonds for the safety of the face value and the chance of equity growth. The risk team sets a limit of 5% of the portfolio for the asset class. It reviews the issuer's credit rating every quarter and records the conversion terms in its investment system. The team also tracks the share price against the conversion price, so it knows when conversion becomes attractive.
Formula
Calculation
Conversion price = Issue price / Conversion ratio
Conversion value = Conversion ratio x Current share price
Conversion premium = (Bond price - Conversion value) / Conversion value
A zero-coupon convertible is issued at $1,000, repays $1,200 in 5 years and converts into 8 shares per bond. The conversion price is 1,000 / 8 = $125. If the shares trade at $100, the conversion value is 8 x 100 = $800, and the premium is (1,000 - 800) / 800 = 200 / 800 = 25%. The yield if held to maturity is about 3.7%, because 1.2 raised to the power 0.2 is about 1.037.Case study
Seen in the real world.
Solaris Robotics is an illustrative, fictional company that needs $60,000,000 to build a new factory. Bank loans would cost 7% a year, or $4,200,000 in interest. Instead, its treasurer issues zero-coupon convertibles at $1,000 each, repayable at $1,200 in five years and convertible into 8 shares.
During the five years the company pays no cash interest, saving about $4,200,000 annually, which it spends on expanding the factory. The board accepts the risk that conversion will increase the number of shares in issue. In the illustrative scenario, the shares rise to $180 and holders convert, receiving 8 x 180 = $1,440 of shares per bond.
The lesson is that the company paid for the funding with equity dilution rather than cash. Solaris's finance team publishes a table showing the shares that could be issued, so investors understand the potential dilution.
Watch out
Common mistakes.
- Treating the bond as a free loan, when the cost is paid through dilution and the discount at redemption.
- Ignoring credit risk, when the holder still depends on the issuer to repay if the shares do not rise.
- Comparing it with a normal bond on coupon alone, when the value of the conversion option is a large part of the return.
Questions
People also ask.
Why would an issuer choose zero coupon?
To save cash interest payments during the bond's life, which is useful for companies investing heavily in growth.
What is dilution?
It is the reduction in existing shareholders' percentage ownership when new shares are issued on conversion.
Can the holder lose money?
Yes, if the issuer defaults or if the bond is sold before maturity at a lower price.
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