Science Fair Project Encyclopedia
A convertible bond is type of bond that can be converted into shares of stock in the issuing company, usually at some pre-announced ratio. A convertible bond will often have a lower coupon rate for which the holder is compensated for by the value of the holder's ability to convert the bond into shares of stock. In addition, the bond is usually convertible into common stock at a substantial premium to its market value.
Other convertible securities include exchangeable bonds (where the stock underlying the bond is different from that of the issuer), convertible preferred stock (similar valuation-wise to a bond, but lower in seniority in the capital structure), and mandatory convertible securities (short duration securities, generally with high yields, that are mandatorily convertible upon maturity into a variable number of common shares based on the stock price at maturity)
From the issuer's perspective, the key benefit of raising money by selling convertible bonds is a reduced cash interest payment. However, in exchange for the benefit of the reduced interest payment, the value of shareholder's equity is reduced due to the expected dilution should the convertible bondholders convert their bonds into new shares.
From a valuation perspective, a convertible bond consists of two assets: a bond and a warrant. Valuing a convertible requires an assumption of 1) the underlying stock volatility to value the option and 2) the credit spread for the fixed income portion that takes into account the firms credit profile and the ranking of the convertible within the capital structure. Using the market price of the convertible, one can determine the implied volatility (using the assumed spread) or implied spread (using the assumed volatility).
A simple method for calculating the value of a convertible involves calculating the present value of future interest and principal payments at the cost of debt and adds the present value of the warrant. However, this method ignores certain market realities including stochastic interest rates and credit spreads, and does not take into account popular convertible features such as issuer calls, investor puts, and conversion rate resets. The most popular models to value convertibles with these features are finite difference ones such as binomial and trinomial trees.
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