The equity value of a convertible bond was determined to be its conversion value. Conversion premium can be calculated easily by simply taking the difference between the current market price of the convertible and the conversion value and expressing it as a percentage. Since the convertible bond is more secure than common stock and generally pays higher interest than the stock dividend, the convertible bond buyer is willing to pay a premium over conversion value. Market forces determine the amount of premium that a particular convertible may command in the marketplace. Determining whether the premium is high or low depends upon other variables to be discussed in later chapters. However, it should make sense that, as a convertible bond price increases above its investment value, its fixed income attributes give way to equity characteristics, decreasing the conversion premium. On the other hand, if the stock price declines, the convertible bond price approaches its fixed income value and the conversion premium increases. Convertible bonds that are trading near their fixed income values with substantial conversion premiums are called "busted converts." Their equity component is of little value, and they trade mainly on their fixed income characteristics.
Figure 2-4 depicts a typical convertible price curve, with the shaded area denoting conversion premium. Notice that as the stock increases in value, conversion premium gradually decreases until it becomes zero. At that point, the convertible market price and conversion value are equal. As the common stock declines in value, the convertible gains conversion premium because it is approaching its investment value.
A Convertible's Conversion Premium
From another perspective, the market value of the convertible should always be higher than either the conversion value or the investment value. If we were to hypothesize a convertible with a market value that exactly equaled its investment value, the investment premium would have a value of zero and the convertible would be trading as if it were a straight nonconvertible bond. However, a convertible security has an implicit option, and as long as there is time remaining before the option expires—thereby providing the holder with equity potential—the option will have some value in itself.
The convertible price curve can be either an estimate of how much conversion premium a particular convertible security would command at various stock prices or an historical depiction of how a convertible has actually traded as the common stock has fluctuated over time. It is an extremely important consideration in evaluating convertible securities because it determines the upside potential versus the downside risk. Detailed mathematical formulae are needed to estimate the convertible price curve accurately. It is inadequate to rely on simple historical price relationships to properly analyze the fairness of the conversion premium level. That process is examined in detail beginning in Chapter 8.
The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.
Past performance is no guarantee of future results.