Convertible Bonds: Bond Floor + Conversion Right

A bond you can turn into stock

A convertible bond pays interest as usual, and you can also swap it for shares at the conversion price: with a $100 face value and a $10 conversion price, you get 10 shares.

A floor on the downside, a share of the upside

When the stock is depressed, it's still worth at least as much as an ordinary bond: the bond floor. When the stock surges, the conversion value rises with it and the convertible follows.

Conversion premium: more bond or more stock?

A convertible ≈ bond floor + a conversion option, so it usually costs more than both the bond floor and the conversion value. How much more than the conversion value it costs is the conversion premium: a low premium behaves like a stock, a high premium like a bond.

Key takeaways

• Shares on conversion = face value ÷ conversion price; conversion value = shares on conversion × stock price.
• The bond floor is its value as a plain bond. However low the stock goes (barring default), the price roughly won't fall below it.
• Convertible value ≈ bond floor + conversion option value, so it's always above the larger of the bond floor and the conversion value.
• Low conversion premium → behaves like the stock (equity-like); high conversion premium → behaves like a bond (bond-like).

Try it yourself

You can do these exercises in this lesson's interactive simulation:

1. Click “Example: stock at $12”: what are the conversion ratio, conversion value and bond floor? By what % does the convertible's theoretical price exceed the conversion value?
2. Click “Stock falls to $4”: how much is the conversion value now? Why didn't the convertible's price fall nearly as much? Which type does the top label switch to?
3. Click “Stock rises to $20”: what does the conversion premium become? If the stock keeps rising, how will the convertible move?
4. Drag “Time to maturity” to 0 (matures today) and look at stock prices of $8 and $14: is the theoretical price exactly the larger of $100 and the conversion value?

Quiz and explanations

1. A convertible bond has a $100 face value and a $10 conversion price, and the stock trades at $12. What's its conversion value?

Answer: $120.It converts into $100 ÷ $10 = 10 shares, and 10 × $12 = $120.

2. In the question above, the convertible trades at $132. Roughly what's its conversion premium?

Answer: 10%.$132 ÷ $120 − 1 = 10%.

3. When the stock crashes far below the conversion price, what mainly supports the convertible's price?

Answer: The bond floor (straight bond value).Converting isn't worth it then, so it behaves more like a plain bond.

Terms in this lesson

• bond floor (Bond Floor): A convertible's value as a plain bond (present value of future coupons and principal), the floor under its price however low the stock goes (as long as the company doesn't default).
• conversion premium (Conversion Premium): How much a convertible's price exceeds its conversion value, in percent; the lower it is, the more stock-like the convertible, the higher, the more bond-like.
• conversion price (Conversion Price): The agreed price per share when converting a convertible bond; shares received = face value ÷ conversion price.
• conversion value (Conversion Value): The market value of the shares you'd get by converting right now = shares received × stock price.
• convertible bond (Convertible Bond): A bond that can be converted into the issuer's shares at a set price: it acts like a bond when the stock is weak and like a stock when the stock soars.