Chapter 7: Convertible Bonds
Convertible bonds are exchangeable for a fixed
number of shares of the issuing company’s stock
at the bondholder’s discretion. The number of
shares exchanged for the bond is determined by
a conversion ratio that’s set at the time the bond is
issued. Stating the conversion along with the
bond’s par value implies a conversion price.
Ordinary bonds are generally safer
investments compared to stocks that offer
price appreciation. A convertible
feature allows bondholders to price.
appreciation if the firm is successful. It is usually
set at 15 to 30 percent above the stock market’s
price at the time the convertible is issued.
This method makes investors accept lower yields
on convertibles than on ordinary bonds. That
means they can be issued at lower coupon rates
and cost borrowers less in interest expense.
Convertibles are less risky than stocks.
Convertibles are always debentures, unsecured
bonds.
To get the return on investment of
convertible bonds:
Shares exchanged = Par value
Conversion Price
1. The answer will be the resulting number of
shares. The proceeds will be multiplied to the
current price of stock.
2. Get the interest payment of the bond with its
coupon rate.
3. Add the market shares price to the interest
payment of the bond. The answer will be the
new bond price.
4. Deduct the new bond price to the face value of
the bond to calculate the gain.
5. Divide the gain to the face value of the bond to
get the percentage of return on investment.
To get the return from common stock:
1. Face value of the note divided by the price of
the common stock to get the shares.
2. Deduct the new price of the stock from the price
of the common stock to get the gain.
3. Multiply the total gain to the shares calculated
to get the price of the stock.
4. Divide the price of the stock to the face value to
get the rate on return.
Effect of Conversion on the Financial Statements
and Cash Flow
During conversion, an accounting entry is made
that takes the par value of converted bonds out of
long-term debt and places it in the equity accounts
as if new shares had been sold at the conversion
price.
There is no immediate cash flow impact from
conversion, but affects ongoing cash flow, and the
transaction is strictly on the company's books. It is
important for the ongoing cash flow because it
makes the original debt go which makes the interest
payments immediately stop, however, the newly
created shares are entitled to dividends if any are
paid.
If the company that issues convertibles doesn’t
pay dividends, it implies a decrease in cash flow.
Conversion also strengthens balance sheet by
removing debt and adding equity, which improves
all debt management ratios.
Convertibles as Deferred Stock Purchases
Convertibles can be thought of as deferred stock
purchases or deferred purchases of equity (stock). A
substantial increase in stock price guarantees
eventual conversion which means that the bond and
associated interest payments can be viewed as
temporary, and the long-term effect of the
transaction is a sale of stock.
Advantages of Convertible Bonds
Advantages to Issuing Companies
1. Offer lower interest rates. Convertible debt
tends to be offered by risky companies that
have problems with conventional borrowing.
Risky businesses often pay higher interest rates
which makes it difficult to borrow. This makes
lenders accept lower rates or lend where they
would not.
a. Companies with a low credit rating and
high growth potential often issue
convertible bonds. For financing
purposes, the bonds offer more
flexibility than regular bonds. They may
be more attractive to investors since
convertible bonds provide growth
potential through future capital
appreciation of the stock price.
b. Companies issue convertible bonds to
lower the coupon rate on debt and to
delay dilution. They trade in relatively
illiquid market.
2. Illiquid – a market that is
3. difficult to sell assets in due to a lack of
interested buyers, available assets, or because
the market itself is not viable as a financial
asset.
4. It can be viewed as a way to sell equity at a
price above the market. They may sell stock
above the market.
5. They have few restrictions. Lenders insist on
reducing their risk with contracts called bond
indentures that limits the activities of borrowers
while debt is outstanding. If the debt is a
convertible debt, lenders view is as purchasing
equity (because they can change bond to stocks)
which makes them less concern with
restrictions (bonds have indentures).
Advantages to Buyers
1. They offer the buyers chance to participate in
stock price appreciation offered by risky equity
investments. (Risky businesses have volatile
interest rates. If it is a bond, the lender may face
a loss because of its fixed rate. If it is a stock,
lenders can convert it to stocks when the stocks
increase. In stocks high risk=high rewards).
2. Limit the risk associated with stock investments
which may cause big gains or loss.
Forced Conversion
Lenders of convertible bonds may delay exercising
the conversion of bonds if they believe that the
current stock price will remain the same all
throughout the years. This enables them to collect
interest until they decide to call it off and then
receive the stock price when they decided to
convert the bonds to stock
 (meaning makakareceive sila ng interest
throughout the years of the bond, tapos pag
ayaw na nila, pwede nila iconvert ung bond
sa prices ng stock para more money).
The management wants to convert their bonds for
two reasons:
1. Avoid paying further interest.
2. Want to exchange debt for equity
(strengthen the balance sheet)
This makes them issue call features to force
conversion which typically have call premiums
of one year’s coupon interest. This makes the
lender either accept the call premium or convert the
bonds to stocks.
Issuers call convertibles when stock prices have
risen to levels that are 10-15 percent above
conversion prices.
Overhanging Issues
Issuing convertibles may not be to borrow money
but may be to sell equity at a price above market.
Convertibles can become problems if stock prices
don’t increase enough to make the bonds’
conversion values more than their call prices
(premiums). Calls won’t force conversion. If the
lender accepted the call price and don’t convert, the
company will be stuck with debt it doesn’t want
(because they would rather have equity to avoid
paying interest and to make its balance sheet
stronger).
Valuing (Pricing) Convertibles
Valuing the convertible is complicated because the
security’s value (price) can depend on either its
value as traditional bond or market value of the
stock which it can be converted.
➢ The convertible value as a bond does not
require it to be at par because it depends on the
interest rate .
➢ Convertibles value as a stock is calculated
as:
Number of shares exchanged for one
bond(conversion ratio) multiplied by the current
stock price. Assuming the bond is convertible to 50
shares of stocks,
Pb = 50Ps
Pb = Price of bond
Ps = Price of stock
 At low stock price, the convertible’s value
as a bond is higher than its value as a
stock. At higher prices, it’s worth more as
stock.
 At ANY STOCK PRICE the convertible is
worth atleast larger of its value as a bond
or as a stock.
The higher the stock and bond value line’s
represents the minimum value of the convertible.
The market value of a convertible lies above the
minimum value line because of the possibility that
the stock’s price will go up and improve the
return, this idea gives the convertible extra value.
The difference between market value and the
appropriate minimum is the conversion premium.
❖ A conversion premium is the excess of a
convertible’s market value over its value as a
stock or bond.
 The minimum values as stock and as a
bond are equal at the intersection of the two
minimum value lines. That point can be
found by substituting the value as a bond
into the equation of the diagonal value as
stock line.
Pb = 50Ps
1000 = 50 Ps Ps = 1,000/50
=20
Effect on Earnings Per Share – Diluted EPS EPS
is net income (earnings after tax) divided by the
number of shares of stock outstanding. It is the
firm’s money-making power stated on a per-share
basis. EPS is a key factor in determining the value
of stocks. Investors decide how much they’re
willing to pay for shares based in large part on
issuing company EPS. Growing EPS is a very
positive sign, a stagnant or declining can lead to
depressed stock price. EPS is related to related
price earnings per ratio because it is the first thing
investors look at.
Dilution
The additional issuance of stock would increase the
value of the company enough to keep the value of
old shares constant. If new shares are issued at a
lower price, new investors would gain higher return
because of the stocks of old investors. The old
investors’ stocks were diluted. Earnings dilution is
a drop in EPS caused by a sale of stock at a below-
market price.
Convertibles and Dilution
Convertible securities cause dilution.
If the convertible bond has a stock price of 25, and
the stock market has 29, the owner of the
convertible would receive 29 but the issuer will
receive only 25.
Dilution happens when a company’s stock price
rises after a convertible is issued. The existence of
unexercised convertibles always represents
potential dilution in a firm’s EPS.
Disclosure of the Dilutive Potential of
Convertibles
Unexercised convertibles may cause smaller EPS
because of their dilutive effect. This made FASB
(Financial Accounting Standards Board) make the
companies report potential dilution from
convertible and certain other securities in their
financial statements. FASB 128 requires that
companies report two EPS figures, basic EPS and
diluted EPS.
 Basic EPS is what you would expect,
earnings after tax divided by the number of
shares outstanding during the year. If the
number of shares isn’t constant during the
year, an average over time is used.
 Diluted EPS is calculated assuming all
existing convertibles are exercised creating
new shares as of the beginning of the year.
 It shows the worst case scenario for
dilution.
How to Calculate Basic and Diluted EPS for the
year:
Basic EPS:
Basic EPS = net income
Shares outstanding
Diluted EPS (new shares issued):
Shares exchanged = bond’s par value
Conversion price
And then:
1. Shares from conversion = issued convertible
bonds x new shares issues (diluted eps)
2. New shares outstanding = outstanding share +
shares from conversion
3. Interest saved = coupon rate x par value x
issued convertible bonds
4. Saved taxes = interest saved x marginal tax rate
5. Improvement in net income from eliminating
interest is interest saved minus saved taxes.
6. Net income for calculating diluted EPS is net
income plus improvement in net income from
eliminating interest.
7. Diluted EPS is net income divided by new
shares outstanding.
Other Convertible Securities
Convertible features can be associated with certain
other securities, such as preferred stock.
Convertible preferred shares are similar to
convertible bonds in that both are potentially
dilutive. They’re treated similarly in the calculation
of diluted EPS.
Securities that are not convertibles can also result in
issuing new stock at prices below the market. Until
exercised they also present potential dilution, the
calculated diluted EPS should be adjusted to them.
A warrant is an example, which gives its owner the
right to buy a limited amount of new stock at a
fixed price during a specified period.
Institutional Characteristics of Bonds
A bond is a device that enables an organization
(generally a corporation or a government unit) to
borrow from a large number of people at the same
time under one agreement.
Registration, Transfer Agents, and
Owners of Record
A record of owners of registered securities is kept
by a transfer agent. Payments are sent to owners of
record as of the dates the payments are made.
Bonds are classified as either:
1. Bearer bonds – belong to whoever possesses
them, a convention that makes them
dangerously subject to loss and theft. They have
coupons attached for the payment of interest.
2. Registered bonds – the owners are called
transfer agents. This is an organization, a bank,
that keeps track of the owners of stocks and
bonds for issuing companies. When one
investor sells a security to another, the agent
transfers ownership in its records as of the date
of sale. On any date, there is a particular owner
of record on the transfer agent’s books for every
bond (and share) outstanding. Interest payments
are sent directly to the owners.
Kinds of Bonds
Secured Bonds and Mortgage Bonds – Secured
bonds are backed by the value of specific assets that
holders can take possession and sell to recover their
claims on the company. Assets tied to a specific
debt are not available to other creditors until that
debt is satisfied. When the securing assets are real
estate, the bond is called a mortgage bond.
Debentures – are unsecured bonds. They rely on
the general credit-worthiness of the issuing
company rather than the value of specific assets.
Debentures are clearly more risky than the secured
debt of the same company. They must be usually
issued to yield higher returns to investors.
Subordinated Debentures and Senior Debt
– Subordinated means lower rank or priority. In
terms of debt, it means having lower priority than
other debt for repayment in the event the issuing
company fails. Debentures can be subordinated to
specific assets or to all other debentures in general.
The debt having priority over a subordinated debt is
called a senior debt.
Subordination arises with the senior debt.
Some security is afforded to the first lender by
writing a clause into the loan agreement requiring
the subordination of all future debt.
Subordinated debt is riskier than senior or
unsubordinated debt, it requires a higher yield.
Junk Bonds – issued by risky company (companies
not in good financial condition) and pay high
interest rate by paying 5 percent higher than strong
companies. They are also called high-yield
securities.
Negative Interest Rates
It happens from time to time in the market for
short-term securities issued by strong governments.
Securities are called bills, not bonds called T-Bills
or treasury bills.
The phenomenon of lending money with little
return happens in secondary markets; when
investors trade the bills among themselves. They do
it for safety of the economy of the country.
Bond Ratings- Assessing Default Risk
Bonds are assigned quality ratings that reflect the
probability of going into default. Higher ratings
mean lower default probabilities. Bond ratings are
developed by rating agencies that make a business
out of staying on top of the things that make bonds
and the underlying firms more or less risky.
They rate bonds examining the financial and market
condition of the issuing companies and the
contractual provisions supporting individual bonds.
It’s important to realize that the analysis has these
two parts.
Bond ratings gauge the probability that issuers will
fail to meet their obligations.
A bond’s strength is fundamentally dependent on
that of the issuing corporation. The process pf
rating a bond begins with a financial (ratio)
analysis. Then, the agencies add any knowledge
they have about the company, its markets, and its
other dealings. For example, suppose a firm has
good financial results and a prosperous financial
outlook but faces a major lawsuit. If the lawsuit is
serious, it can lower the rating.
Bond ratings are NOT precise because they also
rely heavily on qualitative judgments made by the
rating agencies. Rating Symbols and Grades
Investment grade or medium quality have low
default risk
Substandard graded bonds are called junk
bonds.
Why Ratings Are Important
Risk and return are related and investors require
higher returns on riskier investments. Ratings are
the primary measure of the default risk associated
with bonds. They’re an important determinant of
the interest rates investors demand on the bonds of
different companies.
Rating associated with a firm’s bonds determines
the rate at which the firm can borrow. A lower
rating implies the company has to pay higher
interest rates which means it’s more difficult for the
company to do business and earn a profit, because
it’s burdened with a higher cost of debt financing.
All bonds yield interest rates; the differential is
between the rates required on high and low quality
issues. Lower curves associated with high-quality
bonds means that the issuing companies can borrow
at lower rates (more cheaply). Highest quality bond
that can borrow at lower interest rate is the federal
treasury bond (high quality bond indicates the
safety).
A bond’s rating affects the size of the differential
between the rate it must pay to borrow and the rate
demanded of high-quality issues. It does not affect
the overall up and down motion. The differential
reflects the risk of default perceived to exist with
lower quality bonds (default risk premium).
The differential over time – The differential
between the yields on high- and low-quality bonds
is an indicator of the health of the economy. Higher
rates are associated with recessions and tough
economic times. Marginal companies are prone to
fail. The risk of default associated with weak
companies is greater in bad times than in good
times. It expresses level of risk, differential tends to principal to be repaid. This approach is the
be larger in recessionary periods. future value of an annuity.
2. Randomly calling in some bonds for
This phenomenon can be considered an economic
indicator . A high differential is taken as a signal retirement prior to maturity.
that a harder times are on the way. Other terms:
The Significance of the Investment
 Diluted EPS - EPS considers a company’s
Grade Rating common shares, whereas diluted EPS takes
Most bonds are purchased by institutional investors into account all convertible securities, such
such as banks, mutual funds and insurance as convertible bonds or convertible
companies, rather than individuals. The law preferred stock, which are changed into
requires these institutions to make only relatively equity or common stock.
safe, conservative investments and can only deal in  Unexercised convertible bond –
investment grade bonds. This requirement limits the unconverted convertible bond
market for the debt of companies whose bonds are  Exercised convertible bond – converted
not considered investment grade. convertible bond
Is EPS an equity? - The earnings per share (EPS)
ratio is effectively a restatement of the return on
Bond Indentures- Controlling Default equity (ROE) ratio. While the ROE ratio is
Risk calculated as a percentage, taking total net profit
and total equity into consideration, the EPS ratio
The conflict of interest arises because the rewards shows how much profit has been earned by each
of successful risk taking accrue largely to ordinary share (common share) in the year. Bond
stockholders while the penalties for failure can be Outstanding
shared between stockholders and creditors.
Junk bond
To ensure that the bond-issuing companies maintain
an even level of risk, lenders usually insist that Risky enterprise
bond agreements contain restrictions on the Default risk
borrower’s activities until the bonds are paid off.
The contractual document containing such
restrictive covenants is called bond indenture.
Typical indenture provisions prelude entering
certain high-risk businesses and limit borrowing
more money from other sources. They may also
require for certain ratios held above minimum
levels.
Every bond issue has a trustee whose job is to
administer and enforce the terms of the indenture
on behalf of bondholders. Trustees are usually
banks.
Sinking Funds
This spreads the repayment of principal over time.
Two types:

1. Periodic deposits such that amount

available at maturity is equal to the