Portfolio Advisory Group
May 12, 2011
Convertible Debentures – A Primer
A convertible debenture is a hybrid financial instrument
that has both fixed income and equity characteristics. In
its simplest terms, it is a bond that gives the holder the
option to convert into an underlying equity instrument at
a predetermined price. Thus, investors receive a regular
income flow through the coupon payments plus the
ability to participate in capital appreciation through the
potential conversion to equity. Convertible debentures
are usually subordinated to the company’s other debt.
Convertible debentures are issued by companies as a
means of deferred equity financing in the belief that
the present share price is too low for issuing common
shares. These securities offer a conversion into the
underlying issuer’s shares at prices above the current
level (referred to as the conversion premium). In
return for offering an equity option, firms realize both
interest savings, since coupons on convertible bonds
are typically lower than those on straight bonds to
account for the call option, and tax savings as coupon
expenses are deductible for income tax purposes
whereas dividends are paid from after-tax cash flows.
Convertible debentures offer some advantages over
investing in common equity. As holders of a more
senior security, investors have a greater claim on the
firm’s assets in the event of insolvency. Secondly, the
investor’s income flow is more stable since coupon
payments are a contractual obligation. Finally,
convertible bonds offer both a measure of protection
in bear markets through the regular bond features and
participation in capital appreciation in bull markets
through the conversion option. Unlike traditional
bonds, convertible debentures trade on a stock
exchange but generally have a small issue size which
can result in limited liquidity.
VALUATION
A convertible bond can be thought of as a straight
bond with a call option for the underlying equity
security. Therefore, there are two lower boundaries
below which the bond should theoretically never
trade:
• the straight bond value &
• the conversion/intrinsic value
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The intrinsic value of the bond is the current price of
the common stock multiplied by its conversion ratio
(the number of shares that each bond is convertible
into).
CONVERTIBLE DEBENTURES TRADING IN THE MONEY
A convertible debenture will normally trade at the
intrinsic value, or a small premium above the intrinsic
value, when the underlying equity security is trading
above the strike price, or commonly referred to as
trading in-the-money.
When a convertible is trading deep in-the-money,
it will take on the characteristics of the underlying
equity as opposed to a debt obligation. As a result,
the yield-to-maturity can become negative and the
cash-on-cash (ie. coupon divided by prce) yield
can be lower than the underlying dividend yield. If
these conditions exist and the convertible debenture
Convertible
Bond
Price
Market Price of
Convertible Bond
Instrinsic
Value
Straight Bond
Value
Common Equity Share Price
was originally purchased as part of a fixed-income
portfolio an investor should reconsider holding this
security.
REDEMPTION CLAUSES
Prior to buying a convertible, investors should
investigate whether a debenture can be redeemed
prior to maturity. Convertibles typically have a noncall period, followed by a soft call and/or a hard call
to maturity. The non-call period prohibits the issuer
from redeeming the bond without the consent of the
bond holders.
• S
oft Call: The soft call period allows the issue to
be called but provides investors with a capital
gain to offset the loss of interest income. The most
common soft call stipulates that the underlying
equity instrument must trade for a specified period
of time above a certain price level in order for the
bond to be called. Usually, the soft call is set at a
level that allows the convertible bond to trade in
the money and as such the risk of losing capital
under a soft call provision is lower than a hard call
provision.
• H
ard Call: The hard call feature allows the bond to
be called at par, or slightly higher, regardless of the
price of the underlying security.
Why should you be aware of these call options? All
else being equal, a convertible debenture with a
higher coupon should trade at a higher price. In the
current low interest rate environment, companies can
use their hard call option to redeem an outstanding
convertible and issue a new convertible at a lower
coupon. In order to preserve capital, investors need to
be careful when owning a convertible debenture with
a hard call option that is significantly lower than the
current trading price.
In addition to these redemption clauses investors
need to be aware of any soft redemption clauses
which allow the issuer to repay the principal amount
at maturity/redemption by payment of common
shares, as opposed to cash. Most frequently, the
clause will state that the corporation may satisfy its
obligation to repay the principal amount by issuing
and delivering that number of common shares or
units obtained by dividing the principal amount by
95% of the weighted average trading price of the
common shares during a specified period of time
right before maturity. In most cases, receiving units/
shares instead of cash is not an issue since you can
usually sell them into the market relatively easily.
However there are certain situations which could
cause a concern:
• S
uitability: some accounts cannot hold equity so
you may be forced to sell the convertible before
maturity.
• L
ow share price: where the underlying security
trades at a low price and is lightly traded, the bidask spread may be sufficiently wide that it may be
difficult to sell the shares/units and recoup the full
face value.
Convertible debentures that are far out-of-themoney (i.e. the current stock price is well below the
conversion price) will normally trade at or near their
straight bond value, unless the company is under
financial stress. Key pricing considerations include
standard fixed income criteria such as the current
yield, yield to call, yield to maturity and credit
rating (if applicable). Investors should also consider
the balance sheet of the company in question as
convertible debentures tend to be subordinated debt
and clients should note what debt ranks senior to
the debentures. Investors need to also be aware that
convertible debentures are not generally rated by
credit agencies and due to the subordination would
likely be rated and few notches below other bond
or debentures of the same firm. Many currently
outstanding convertible bonds would be considered
below investment grade.
Convertible bond pricing becomes most interesting
when dealing with issues that are at-the-money. It
is here that the bond’s call option value becomes
fundamental in determining the bond’s fair value.
Key considerations when evaluating an at-themoney convertible include conversion premium (the
lower the better), and call protection (the longer the
better). Unfortunately, no rule of thumb exists about
what constitutes an attractive conversion premium.
Comparative analysis of at-the-money debentures of
similar credit quality will highlight attractive issues.
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