What is a Convertible Bond?
Convertible bonds represent a debt of the issuing corporation and are commonly designated by the rate of interest paid and the year of maturity. The price at which a convertible is traded is quoted as a percentage of $1,000 (or par). For example, the convertible noted as: Actuant 2s2023 priced at 104.27 in The Value Line Convertible Survey means Actuant is the issuer; coupon rate is 2% annually, the year of maturity is 2023, and the price is $1,042.70 (or 104.27% of par).
Usually convertible bonds are subordinated debentures: that is, their claim to the assets of the issuing corporation is subordinated to that of senior issues. In the event of bankruptcy, liquidation or dissolution, senior debt obligations would be satisfied before subordinated debenture holders were repaid. On the other hand, holders of subordinated debentures usually have a higher claim to the assets of a corporation than owners of common or preferred equity. The actual privileges of each convertible bond differ and may be superior or inferior to the usual issue described above. A description of the rights provided by any particular convertible bond will be found in the bond’s indenture, which can be obtained from the issuing company. Other legal covenants contained in the indenture include:
Face Value and Rate of Interest: The face value (or par value) of a bond is its value at maturity, usually $1,000. It is also the value used in calculating interest payments. Thus, a bond with a 5% coupon pays $50 a year in interest, usually in semi-annual installments. The indenture also states the dates on which the interest must be paid and the recourse of the owners if the company defaults on the payment of interest or principal.
Redemption Price and Maturity Date: The sale of bonds by a corporation is the borrowing of money. So, when bonds are sold, the corporation stipulates the maturity date in the indenture; that is, the date it will repay the principal of the loan. Corporations will also make provision for early retirement of the loan. That is to say, the issuing company may retain the option to “call” or redeem the bond before it reaches maturity at a small premium over face value. This call price or redemption price is highest in the early years of the loan; then it gradually decreases until it is equal to the face value at or prior to maturity. The redemption prices are set by the issuer when the bond is issued. A company will not generally call a bond selling below par. And, since most convertible bonds, when called, are trading well above par, failure to act by either selling or converting will usually cause large losses.
Conversion Features and Dilution Protection: If a bond is convertible, the indenture will specify the conversion ratio, the number of common shares into which it can be converted. Alternatively, it may specify the conversion price. When only the conversion price is given, the conversion ratio can be calculated by dividing the face value by the conversion price. For example, if the face value of the bond is $1,000 and the conversion price is $25, then the conversion ratio is 40 shares of stock ($1,000/$25 = 40). Although convertible bonds can be converted immediately after issuance, sometimes conversion may be delayed. That is, the bond may not be converted into stock until a later specified date. Moreover, not all convertible bonds are convertible into common stock. Some may be wholly or partially convertible into preferred stock and/or other equities.
In addition to specifying the equity into which the bond is convertible, the indenture specifies under what circumstances and in what manner the bondholder will be converted.