Features of a Convertible Bond

A convertible bond is a hybrid instrument with a conversion option that gives the owner the right to convert debt into equity during a predetermined period (conversion period) at a predetermined price (conversion price).

Investors can participate in the potential upside through the conversion mechanism while protecting the downside with cashflows from the coupon payments and the face value at maturity.

The conversion price and conversion ratio characterize a convertible bond. The conversion price is the share price at which bondholders can convert their bonds into common shares. On the other hand, the number of common shares that the bondholder gets from converting the bond into common shares is called the conversion ratio.

$$ \text{Conversion ratio} =\frac{\text{Issue price}}{\text{Conversion price}} $$

Example: Conversion Price

The following information relates to a convertible bond issued by XYZ Inc.

$$ \begin{array}{c|c} \text{Issue date} & {01 \text{ July } 2020} \\ \hline \text{Maturity date} & {30 \text{ June } 2024} \\ \hline \text{Interest rate} & 5.00\% \\  \hline \text{Issue size} & 1,000,000 \\ \hline \text{Issue price} & $100 \\  \hline \text{Conversion ratio} & 2.58 \\ \end{array} $$

The conversion price of the bond is closest to:

Solution

$$ \begin{align*} \text{Conversion ratio} & =\frac{\text{Issue price}}{\text{Conversion price}} \\ \\ 2.58 &=\frac{100}{\text{Conversion price}} \\ \\ \text{Conversion price}& =\frac{100}{2.58} =$38.76 \end{align*} $$

Question

A company issues a convertible bond at $800 with a face value of $1,000, which pays 6% annual coupons. The bond can be converted to 15 common shares, which are traded at per share. https://www.colombia.co/ The market price of the convertible bond is $700.

The conversion price of the bond is closest to:

1. $2.67.
2. $40.00.
3. $53.33.

Solution

The correct answer is C.

$$ \begin{align*} \text{Conversion price}& =\frac{\text{Issue price}}{\text{Conversion price}} \\ \\ \text{Conversion ratio} &=\frac{800}{15}=$53.33 \end{align*} $$

Reading 30: Valuation and Analysis of Bonds with Embedded Options

LOS 30 (n) Describe defining features of a convertible bond.