Convertible Bonds

Bonds that can be exchanged at their owner's discretion for more junior securities are known as convertibles. The conversion feature can be expressed as a ratio or as a price. Either is readily convertible into the other. For example if a $1,000 bond can be exchanged for 20 shares of common stock in its issuing company the conversion ratio is 20. Furthermore, the conversion price is calculated by dividing the bond's face value by the conversion ratio. Thus $1,000/20 = $50. So the equivalent conversion price for this conversion ratio of 20 is $50. Note that the conversion price and ratio typically do not change. Thus the desirability of converting a bond often relates to the comparison of the stock's market price with the bonds conversion price.

A conversion premium can be calculated when the conversion price exceeds the stock's market price. Continuing the above example, if the stock presently sells for $30 per share it has a conversion premium calculated as ($50 - $30)/$30 x 100 = 66.67%.

Conversion of such bonds is unattractive as long as the conversion price remains below the market price. Normally, when these bonds are sold that relationship holds. Later, as the common stock appreciates its market value exceeds the conversion price and the conversion process becomes attractive. In this case conversion becomes attractive when the stock's market price exceeds $50 per share.