Convertible bondsare corporate bonds that owe their name to the fact that they have the potential to be converted into common stock of the issuing company. Compared to traditional bonds, convertible bonds are more sensitive to company-specific news and less sensitive to systematic economic conditions. Consequently, their valuations must consider the same factors as their equity counterparts, because they may one day become those very same equities themselves.
It should be noted that the equity conversion option acts like a call option for the underlying company's stock. And like call options, value changes based on the variance in underlying stock price, conversion ratio, interest rates, and the maturity of the option instrument.
Key Takeaways
- Convertible bonds are corporate bonds that may be converted into common stock of the issuing company.
- Convertible bonds are more sensitive to company-specific news and less sensitive to systematic economic conditions than traditional bonds.
- Convertible bond valuations take a multitude of factors into account, including the variance in underlying stock price, conversion ratio, and interest rates that could affect the stocks that such bonds might eventually become.
The Role of Valuations
The financial term "valuation" refers to a process of determining a financial asset's fair value. Nearly all valuation models seek to determine the present value of an asset's expected future cash flows.
With traditional bonds, which boast fixed maturity dates and contractually locked in payouts, this calculation process is straightforward. But determining this metric can become thornier for convertible bonds because the potential post-conversion price of the resulting equity is intrinsically harder to predict.
Traditional Bond Valuation
Traditional bond valuation involves the following three steps:
- Estimating the expected future cash flows
- Determining a reasonable discount rate for future cash flows
- Applying the discount rates to the expected future cash flows, in order to arrive at a present value
Future cash flows should be equal to the yet-unpaid coupons left before maturity plus the face value of the bond at maturity. Discount rates cannot be set as neatly; they must be adjusted as current yields adjust.
The relationship between bond value and discount rates is the same as the relationship between bond prices and yields. The lower the discount rate is, the higher the value of the bond becomes. Conversely, the higher the discount rate is, the lower the value of the bond becomes.
Convertible Bond Valuation
Convertible bonds have an embedded ability to be converted into stocks. This is sometimes referred to as the "equity participation feature." There are multiple methods for valuing convertible bonds. Some are relatively simple, while others are substantially more involved, especially the ones that attempt to determine the conversion premium per share.
Convertible bonds are typically issued by companies with low credit ratings and substantial growth potential.
Furthermore, investors should anticipate how the impact of interest rates on stock prices could ultimately affect convertible values.
To accomplish convertible bond valuations, investors may rely on the following formula:
- Value of convertible bond = independent value of straight bond + independent value of conversion option
FAQs
Compared to traditional bonds, convertible bonds are more sensitive to company-specific news and less sensitive to systematic economic conditions. Consequently, their valuations must consider the same factors as their equity counterparts, because they may one day become those very same equities themselves.
What is the difference between a convertible bond and a traditional bond? ›
First, convertible bondholders have the option to participate in the company's equity. While a regular bond is simply a debt instrument, a convertible bond gives investors the opportunity to benefit from capital appreciation if the company's stock price increases.
Why would an investor prefer a convertible bond? ›
Lower interest payments
Generally, investors are willing to accept lower interest payments on convertible bonds than on regular bonds. Thus, issuing companies can save money on their interest payments.
What are the 3 ways a bond is valued and why do bonds have different values? ›
As the bond's price fluctuates, the price is described relative to the original par value, or face value; the bond is referred to as trading above par value or below par value. Three factors that influence a bond's current price are the issuer's credit rating, market interest rates, and the time to maturity.
What is the difference between a bond and a convertible note? ›
Unlike other bonds, convertibles also give the holder the right to convert the bond into shares of stock. Investors like convertibles because they offer protection against heavy losses, but they also give up some value in appreciation.
How do you value a convertible bond? ›
To accomplish convertible bond valuations, investors may rely on the following formula: Value of convertible bond = independent value of straight bond + independent value of conversion option.
How are convertible notes valued? ›
The basic concept for valuing a convertible note is the same in theory as the valuation of any other financial asset. The value of the note is equal to the present value of the future income that the convertible note will receive, discounted to the present value based on its associated risk.
Why is it difficult to value a convertible bond? ›
The valuation of a convertible bond is made more difficult due to the underlying characteristics. When pricing, one must consider the underlying bond and equity details. For example, the equity price, maturity, coupon, volatility and spread must all be considered.
Why are convertible bonds preferred? ›
Investors are often attracted to convertibles' reduced vulnerability to interest rate moves. The equity characteristics of convertible bonds have made them less susceptible to rising interest rates than non-convertible bonds. Many investors may welcome the reduced duration risk of shorter maturities as well.
What are the cons of convertible bonds? ›
Here are some of the cons of investing in convertible bonds:
- Lower Yields: Compared to traditional corporate bonds, convertible bonds typically offer lower yields. ...
- Market Risk: The price of convertible bonds is affected by market conditions, interest rates, and the stock price of the issuing company.
Key Takeaways
- Understanding risk, including the risks involved in investing in the major asset classes, is important research for any investor.
- Generally, CDs, savings accounts, cash, U.S. Savings Bonds and U.S. Treasury bills are the safest options, but they also offer the least in terms of profits.
The bond valuation formula can be represented as: Price = ( Coupon × 1 − ( 1 + r ) − n r ) + Par Value ( 1 + r ) n . The bond value formula can be broken into two parts for better understanding. The first part is the present value of the coupons, and the second part is the discounted value of the par value.
How much is a $1000 savings bond worth after 20 years? ›
After 20 years, it doubled in value ($1,000) and continued to earn interest ($600) until reaching maturity after 30 years. If you redeem your bond today, you can redeem it for $1,600 and spend that on goods or services or reinvest that money in a new savings bond.
Do convertible notes always convert to equity? ›
Some convertible notes have an automatic conversion at maturity. Conversion Provisions: The primary purpose of a convertible note is that it will convert into equity at some point in the future. The most common method of conversion occurs when a subsequent equity investment exceeds a certain threshold.
What is the difference between a convertible bond and a corporate bond? ›
A convertible bond is a corporate bond that can be converted by the holder into the common stock of the issuing company. Convertible bonds offer the buyer an opportunity to exchange the bond for a pre-determined number of shares of the company.
What is the difference between convertible bonds and non convertible bonds? ›
Based on convertibility, there are two kinds of debentures which are convertible and non-convertible debentures. Convertible debentures are debentures that can be converted into equity of the company. In case of non-convertible debentures, they cannot be converted into equity shares of the company.
What is the primary advantage of a convertible bond? ›
The main advantage of convertible bonds is that they provide both exposure to equity markets and some level of downside protection.
What is the difference between a convertible bond and a preferred bond? ›
Convertible preferred shares typically pay a fixed cash dividend out of a company's retained earnings. Convertible bonds pay a coupon rate, which is a periodic interest payment.
