As we have explained before convertible bonds are usually unsecured bonds issued by companies that investors can convert into common stock within a certain period. Each bond can be converted into a certain quantity of shares, which is referred to as the conversion ratio.
The conversion ratio can be calculated using the following formula:
Conversion Ratio (CR) = Number of common stock shares / Number of bonds.
For example, if a $1000 par value bond can be converted to 20 shares of common stock, the conversion ratio is 20.
CR = 20/1
If we know the share price instead of the number of shares, then we can also calculate the conversion ratio by dividing the par value of the bond by the share price.
For instance, if the price of the share is $20, then the conversion ratio is:
CR = Bond’s par value/share price.
$1,000/$20 = 50 shares
The quantity of converted shares that amounts to the bond’s face value constitutes a conversion price.
To calculate the conversion price, we should divide the face value of the bond by the conversion ratio:
Conversion Price (CP) = Face value of the bond/Conversion Ratio (CR)
In application to our example above the conversion price is
CP = $1,000/20=$50.
Some bonds designate different conversion ratios, or different conversion prices, for different periods. For example, the bond indenture may specify that in the first 10 years, the bond’s conversion rate may be 20 shares, after that it will change to 40 shares.
The conversion value indicates the present market value of ordinary shares that the bond can be converted into. Conversion value helps investors understand how the current market value of the stock compares to the current market value of the bond and make the right investment decision. Conversion value can be calculated as follows:
Conversion Value = Conversion Ratio × Current Share Price
Usually, when the bond is issued initially, the bond price significantly exceeds the conversion parity price. The surplus difference between the price of the convertible and the conversion value of the common stock that this bond can be converted into in the future is called the Conversion Premium.
Conversion Premium = Bond Price - (Stock Price × Conversion Ratio)
For instance, a bond is currently selling in the secondary market for $1,200. It can be converted to common stock at a conversion ratio of 20, and the common stock is selling for $50. The conversion premium, in this case, will be:
Conversion Premium = $1,200 - ($50 × 20) = $1,200 - $1,000 = $200.
if this bond currently trades on the market for $1,200 and can be converted into 10 shares of stock, whereas the current stock price is $120, then the stock price and bond price would be at parity. If the stock trades for less than $120, then it means that trades below parity, and if it is selling for over $120, then the stock is selling above parity. Conversion Parity indicates such a relationship between the stock price and the bond price at which their values are equal.
If the market price of the common stock rises above the bond’s par value, the convertible bonds have the attributes of equity, but if the market price is significantly lower than the bond’s face value, then the bond behaves like a regular, non-convertible bond.