Equities · E7 · 9 min
Convertible bonds
Work out what a convertible bond is worth as shares, say whether it behaves like a bond or like the shares, and hedge it with a short.
In the news: “Company raises £500m in convertible bonds and its shares fall 5%”: why companies issue them and why the shares dip.
The essentials
- Convertible bond
- A bond the holder can swap for a fixed number of shares, the conversion ratio: £100 converting into 20 shares sets a conversion price of £5. Because that right has value, it pays less interest than a plain bond.
- Parity and premium
- is the bond’s value as shares: 20 shares at £4.20 is 84 per £100. A convertible at 98 trades at a of 16.7% over that.
- Bond floor
- The convertible’s value as a plain bond, ignoring the right to convert: where it heads if the shares collapse. It is not fixed: if the company’s credit weakens, the falls.
- Equity-like or debt-like
- With the shares far above the conversion price, the premium is small and a convertible moves almost one for one with them; near the floor it moves with the company’s credit. Bigger expected share swings raise its value.
- Convertible arbitrage
- Buying the convertible and shorting its × the shares it converts into: £10m of bonds at 20 shares per £100 with a delta of 0.55 means shorting 1.1 million. That shorting is why shares often dip at launch.
Parity and conversion premium
Premium = (price − parity) ÷ parity, where parity = ratio × share price
- price
- the convertible’s price per £100 of bond
- ratio
- shares received for each £100 of bond
- parity
- the bond’s value as shares, per £100
How it works
1. A loan you can swap for shares
A is a loan to a company with one extra choice for the lender: swap the bond for a fixed number of shares instead. Lend £100 for five years and you get interest along the way and your £100 back at the end, or, if you choose, a set number of shares, say 20. That number is the conversion ratio.
2. The conversion price
Divide £100 by the 20 shares and each share costs you £5 if you convert. That is the conversion price. It is usually set well above the share price when the bond is sold. If the shares climb past £5, converting beats taking the £100 back.
3. Why the interest is lower
The right to convert is valuable, so investors accept a lower interest rate than on a plain bond from the same company. The company borrows cheaply. If its shares soar and investors convert, it has in effect sold new shares at a higher price than they were worth when it borrowed.
4. Parity: the value as shares
What would the convertible be worth if you converted right now? Conversion ratio × share price. With 20 shares per £100 and the shares at £4.20, that is £84 per £100 of bond. This is called . Convertibles are quoted per £100, like other bonds, so parity here is 84.
5. The premium over parity
Convertibles usually cost more than parity, because they also protect you if the shares fall. The extra, as a % of parity, is the . A convertible at 98 with parity at 84 has a premium of (98 − 84) ÷ 84 = 16.7%.
6. The bond floor
If the shares collapse, you can still hold the bond for its interest and your £100 back. Its value as a plain bond is the . The floor depends on how likely the company is to repay: if its finances weaken, investors demand more interest, and the floor drops.
7. Like the shares or like a bond
When the shares are far above the conversion price, the premium is small and the convertible moves almost one for one with the shares: it is equity-like. When the shares are far below it, the price sits near the floor and moves with the company’s credit: debt-like. In between, both matter: balanced.
8. Hedging with a short
A convertible’s says how much it moves for each move in the shares it converts into: 0.55 means 55% as much. buys the convertible and shorts delta × those shares, so small moves cancel. £10m of bonds at 20 shares per £100 converts into 2 million shares; × 0.55 = 1.1 million shorted. That shorting is why shares often dip when a convertible is launched.
9. What moves a convertible
Three things. The shares: when they rise, the convertible rises too. The company’s credit: when it worsens, the floor falls and the convertible with it. And how much the shares swing: the bigger the expected swings, the more the right to convert is worth, so the convertible rises.
Worked example
Each £100 of a convertible converts into 20 shares. The shares trade at £4.20 and the convertible at 98; its bond floor is 88. You buy £10m of the bonds; their delta is 0.55.
- Parity = 20 × £4.20 = 84.
- Premium = (98 − 84) ÷ 84 = 16.7%.
- It sits 14 points above parity and 10 above its floor: balanced.
- Shares on conversion = £10m ÷ £100 × 20 = 2,000,000.
- Hedge = 0.55 × 2,000,000 = 1,100,000 shares sold short.
Parity 84, premium 16.7%; short about 1.1 million shares to hedge.
Check yourself
9 quick questions on the explanation above.
Practice
New numbers every set. Misses and guesses go into your review deck.
In the interview
Answer out loud in under a minute, then compare.
Why would a company issue a convertible?
What’s the bond floor?
Explain convertible arbitrage.
Remember
Premium = (price − parity) ÷ parity
A convertible is a bond plus the right to swap into shares: near its floor it trades like a bond, close to parity it trades like the shares.