How to Price Convertible Bonds?

Some common momentum indicators include:

  • Convertible Security: Debt security that can be converted into a specified number of shares of the issuer’s common stock at the option of the security owner.
  • Exchangeable Security: Debt security that can be converted into a specified number of common stock shares for a company other than the exchangeable security issuer.

Convertible Bond Analysis Process

  • Calculate Conversion Value: which is the current market value of the shares that the bond can be converted into.
    • Conversion Value = Market Price per Common Share * Conversion Ratio
    • Straight Value: price where the bond would trade if it were not convertible to stock.
    • Minimum Value of a Convertible Bond: a convertible bond should, at the lowest, trade at the higher of either the conversion value or straight value.
  • Calculate Market Conversion Price: which is the price per share paid when buying the convertible bond and turning it into stock.
    • Market Conversion Price = Convertible’s Market Price / Conversion Ratio
  • Calculate Market Conversion Premium per Share: which is the excess paid per share when the convertible is bought and converted rather than simply buying the common stock.
  • Market Conversion Premium per Share =Market Conversion Price – Current Market Price per Share of Stock
  • Calculate Market Conversion Premium Ratio: which is the share price mark-up percentage when the convertible is bought and converted rather than simply buying the common stock.
    • Market Conversion Premium Ratio = Market Conversion Premium per Share / Current Market Price per Share of Stock
  • Calculate the Premium Payback Period: which is the length of years it takes an investor to earn back the conversion premium, given the higher income yield on the bond than the income yield on the stock.
    • Premium Payback Period = Market Conversion Premium per Share / Extra Income per Share
    • Extra Income per Share = (Bond Coupon Interest – (Conversion Ratio * per Share Dividend)) / Conversion Ratio
  • Calculate Premium over Straight Value: this value helps investors interpret downside risk of a convertible bond because the convertible will not trade below its straight bond value.
    • Premium over Straight Value = (Market Price of Convertible / Straight Value) – 1
  • When thinking in a realistic manner about convertible bonds, the convertible bond for a company will trade more like a straight bond when the stock price is low because the convertible option has almost no value. Alternatively, the convertible bond will trade more like a stock when the company’s share price is high because the conversion option has value.

Option Based Valuation for Convertible Bonds

As an alternative to the approach outlined in the prior segment, an analyst can take apply option prices to value a convertible bond.

Price convertible bond = Price straight bond + Price stock call option – Price bond call option + Price bond put option

  • The bond call is applicable if the issuer’s convertible bond is callable.
  • The bond put is applicable if the issuer’s convertible bond is putable.

Note that this formula is an identity, so any one variable can be solved for if the other variables are known.

Risk/return Profile of a Convertible Bond

When thinking about the risk/return profile of a convertible bond, consider:

  • The convertible bond will outperform the company’s stock, when the stock does not change in value because the interest income from the bond is usually higher than the dividend of the stock.
  • The convertible bond will outperform the company’s stock, when the stock declines in value because the convertible has a “price floor” equal to the straight bond value.
  • The convertible bond will underperform the company’s stock, when the stock appreciates significantly because the investor paid a conversion premium on the convertible bond.
Series NavigationValuing an Option Embedded Bond using Binomial Interest Rate Tree

Tags: , ,

One Response to “How to Price Convertible Bonds?”

  1. Dora April 20, 2014 at 1:10 pm #

    This paper shows how to price convertible bonds correctly
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2400101

Leave a Reply