You'll learn all about convertible bonds in this tutorial, from accounting and valuation to the "Cost of Convertible Bond" calculation. For the written guide and Excel files, please see the links below the Table of Contents:
Table of Contents:
0:00 Introduction
2:20 Part 1: Typical Terms and Conversion Options
5:23 Part 2: Which Companies Issue Convertible Bonds?
9:25 Part 3: Convertible Bonds on the Financial Statements
16:00 Part 4: Convertible Bond Valuation & Black-Scholes
20:01 Part 5: Payoff Diagrams and Payback Periods
24:01 Part 6: Blended Cost of Convertible Bonds
29:05 Recap and Summary
Files & Resources:
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KEY POINTS:
To analyze and value convertible bonds, you must split them into their Liability and Equity components.
People often claim that convertible bonds are "cheaper" than traditional bonds that cannot convert into shares, but this is not true.
Their cash cost is lower because the coupon rates on convertible bonds are lower, but the "all-in cost" - factoring in their potential to convert into shares - makes them *more expensive* than traditional debt.
You can estimate the # of shares a convertible may convert into by calculating the Conversion Ratio, or Par Value / Conversion Price, and multiplying it by the # of Convertible Bonds, or Bond Principal / Par Value.
To simplify, it's just Bond Principal / Conversion Price.
On the financial statements, a convertible bond may be recorded as a single liability (most common under U.S. GAAP) or split into liability and equity components (more common under IFRS).
The "single liability" treatment means the company will only record the cash interest on the bond and the issuance fee amortization for the interest expense.
With the "split" treatment, the company records the amortization of the bond discount as well, which is based on the equity component / term of the bond; this greatly increases the interest expense but is mostly non-cash.
Convertible bonds are issued most often by high-growth, speculative companies because they act as "hedged equity" for investors. If the company performs well, they capture the equity upside, and if not, they at least get their money back when the bond matures.
To value a convertible bond, you can use the PRICE function in Excel for the liability component, and for the equity component, you can use Black-Scholes to value each call option in the issuance and sum them up.
The more volatile the company's stock and the closer its current share price and the Conversion Price, the more valuable the convertible bond is.
You can also create "payoff diagrams" that show the convertible bond's value or market price vs. its payoff value, or what bondholders earn at different share prices.
Because of the downside protection and the potential equity upside, convertible bonds are worth more than their payoff values even when the share price is below the Conversion Price, and they remain that way above the Conversion Price.
You can calculate the "Blended Cost" of a convertible bond by separating it into liability and equity components, taking a weighted average, and using some option math to estimate the Cost of the Conversion Option, which equals Risk-Free Rate + Equity Risk Premium * Option Beta.
The "Option Beta" is usually much higher than the company's Levered or Relevered Beta because the option's price is much more sensitive to changes in the underlying stock price.
As the company's stock price increases, the Cost of the Convertible Bond moves closer to the Cost of Equity; as the stock price decreases, the Cost of the Convertible Bond moves closer to the After-Tax Cost of Debt.
You can use these types of metrics and analyses to determine how appealing a convertible bond issuance will be to investors, how it should be marketed, and if any of the terms should change.
