A convertible bond is a security issued by a company for the
purposes of borrowing money. In addition to the usual features of a bond
(coupon rate, payment interval, face value, maturity date), a convertible bond
has been endowed with the added benefit of being converted into common
(sometimes preferred) stock. This leads to new features which the buyer must be
well aware of before buying this instrument.
First is the conversion price; this is the price at which a
convertible bond can be converted into stock. The conversion price goes hand in
hand with the conversion ratio which is simply calculated as the face value of
the bond divided by the conversion price. To go a step further, we can
determine the value of doing a conversion simply by multiplying the conversion
ratio by the current stock price.
If that result is greater than the amount paid for the bond,
then the bond is said to be ‘in-the-money’ (same expression and sentiment as in
the options world). When a convertible bond is in-the-money, a certain part of
its trading price is derived from this fact. That amount is referred to the conversion
premium and is obviously exclusive to convertible bonds.
Obviously, a portion of the bond’s value remains fixed; this
is the traditional value derived from face value and coupon rate and is typically
called investment value or bond value. This is sometimes also referred to as
the floor value, since the bond should never trade below this value. The
conversion option on the bond is exactly that, an option, so the minimum value
of it is 0. If the option part of the bond is worthless, (unlikely since there
should be some time value, unless we are very close to maturity) it still has
the value equivalent to any other bond of equal credit rating paying that
coupon and face value. For that reason we state again that a convertible can
never trade below its bond value.