Analysis of Convertible Bonds

by Herb Kirchhoff

Convertible bonds are corporate debt securities that can be exchanged for common stock of the company. Convertible bonds give owners current income in the form of interest payments, plus the possibility of equity capital gains in the future. As bonds, a convertible’s value depends on prevailing interest rates and the credit rating of the issuer. But because they can be turned into stock, convertible bonds’ value also can vary depending on the price of the company’s stock.

Conversion Ratio

Most convertible bonds allow owners to convert bonds into stock according to a ratio set at the time the bond was issued. This “conversion ratio” affects the analysis of whether to keep the bond or convert it. For instance, Acme Corp. issued a $100 convertible bond allowing owners to convert that bond into four shares of Acme stock, which was trading at $25 a share at the time the bond was issued. If Acme stock stayed around $25, then the investor would decide whether to convert or hold based on whether the interest payments on the bond were greater or less than the dividend payments he would get if he converted the bond to stock.

Stock Falls

If the Acme stock fell to $10 per share, the convertible bond would be “busted” because no one would convert a bond worth $100 into shares of stock worth only $40. The busted convertible would trade in the market as just another bond with a price based on interest yield and creditworthiness. The company’s stock price would have no effect on the market value of the bond. But if the stock was rising once more and was nearing the old $25 mark, convertibility would again become important in evaluating a convertible bond.

Stock Rises

If Acme stock rose above $25, the convertible bond would be “in the money,” and the decision to hold or trade would take on a very different color. If Acme stock rose to $30 a share, the owner of the $100 bond could exchange it for four shares of stock worth $120. But he might get a bit more if he sold the bond to another investor instead of exchanging it for stock. The market price of the $100 bond would rise to slightly above $120 because the bond buyer would be collecting interest payments on the bond as well as having the right to convert it to $120 worth of stock. At this point, the bond’s market price would rise and fall in line with the company’s stock price.

Selecting Bonds

There are a number of bond mutual funds in the market that specialize in convertibles. However, if you want to pick your own convertible bonds, you need to evaluate the company both as a bond issuer and stock issuer. You need to consider the company’s current credit rating, market prices of its various bonds, and its history of making regular and reliable interest payments on its bonds. You also need to analyze its stock market performance, paying close attention to its general financial health, quality of management, stock dividend record and earnings potential.

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