What is a Convertible Bond?

A convertible bond is a bond with an embedded derivative that allows for the conversion of the bond into equity, at the choice of the investor in the bond.

If the bond is converted, the bondholder would receive equity in the form of shares or cash equaling the market value of the shares. Convertible bonds are complex financial instruments with variations in their structure. There is no standard design of such instruments.

Key Learning Points

  • A convertible bond is a bond that can be converted into equity. This conversion right is referred to as an embedded derivative, a component of a hybrid financial instrument that also includes a non-derivative host, the bond in this circumstance
  • Upon conversion, bondholders receive equity in the form of either shares in the bond issuing company or as cash equaling the market value of shares
  • Convertible bonds give investors a choice to either hold the bond or exercise their option and convert the debt into equity. Most convertible bondholders hold the bond until maturity or closer to the embedded option
  • Convertible bonds pay lower cash interest than regular bonds as they have an equity component, which is valuable to the investor. This feature makes convertible bonds an attractive financing option for companies that wish to save on their cash interest expense
  • The accounting treatment of convertible bonds varies under US GAAP and IFRS. Depending on the terms of conversion, the accounting rules may require the convertible bond to be treated as equity, or as debt, or to be split between equity and debt

Features of a Convertible Bond

Convertible bonds differ from regular bonds. Regular bonds pay interest, referred to as the coupon, between the issue date and the maturity date, and upon maturity, the debt is repaid in the form of cash. Convertible bonds also involve regular coupon payments similar to regular bonds, however, there are differences in the holding period, the form of repayment, and the amount of interest paid.

Holding Period

The holding period is the amount of time an investment is held by an investor. Convertible bondholders can hold the bond to maturity and redeem it at par value if the company’s stock price has decreased since the bond’s issue date (and conversion will lead to a loss). Alternatively, if the embedded derivative is in-the-money (the market price of the underlying asset is above the effective strike price), the bondholder can exercise their option and convert the instrument into equity. The strike price is the price at which the underlying option can be exercised and, for a convertible bond, can be calculated by dividing the par value of a bond by the number of shares that bond can be converted into.

Most holders of such instruments hold the bond and do not exercise it until close to the expiry date. They do so because the embedded option has time value before the conversion date due to the uncertainty related to its cash flows.  If the bond is converted, the time value is removed because there is no uncertainty post conversion.

Convertible bonds can also have other embedded options added, such as a call feature. Such bonds can be ‘called’ or redeemed early by issuers

Lower Cash Interest than Regular Debt

Companies issue convertible bonds as they typically have a lower coupon, meaning they result in a lower interest cash outflow than an equivalent non-convertible bond. The embedded derivative has value, which means investors may be willing to accept a lower coupon rate. This is not costless for the company, since if the bondholder uses the conversion feature, there will be more shares created in the company, diluting the ownership rights of the existing shareholders.

Accounting for Convertible Bonds

The accounting treatment of convertible bonds is different under US GAAP and IFRS.   from the debt element. In rare cases, companies can hold the instrument at fair value (where the instrument gets revalued regularly to reflect its market value). The accounting treatment under US GAAP is much more complicated.

Also, depending on the exact terms of conversion, the accounting rules may require that the convertible bond is treated either as a liability or as equity. In some cases, accounting rules may require the instrument to be split with one one part treated as equity and another as a liability. If the accounting rules require the convertible bond to be held at fair value, the issuer needs to record any changes in the fair value through the income statement.

Example: Convertible Bond

In this example, we will assume that the accounting treatment requires the bond and the embedded option to be shown separately within the balance sheet and that the embedded option should be treated as equity. Based on the information below, show the accounting for the issuance and the final conversion of the convertible bond.

The bond par value is the amount of debt raised by the company. It pays a coupon of 5% and matures in 4 years. The conversion ratio for this convertible bond is 10 shares for each $1000 par value held.

This means that if the price is over $100 per share (the exercise price or the strike price), the investor would benefit from converting the bond into shares. This happens since 10 shares valued at more than $100 each are worth more than the $1000 that the investor would receive in cash if the bond were not converted at maturity. Since the share price is $120, it makes sense to convert the bond to shares.

Accounting Treatment at Issuance

The company receives cash proceeds of 1,000, which increases assets (cash) by this amount.

For recording the liability, under IFRS, we start by taking the fair value of the convertible note (1,000). This includes the value of the bond as well as the value of the embedded option.

Next, we value only the bond element in isolation. This is done by taking the yield of a similar non-convertible bond but (7% in this example). This yield is then used to calculate the value of the bond if there was no conversion feature. Using the PV function in excel, the debt element of the convertible bond is valued at 932.3.

The difference between the convertible bond’s fair value and the equivalent non-convertible bond’s value is the value of the embedded option (67.7). This is an addition to the equity section of the company’s balance sheet. The company’s assets have increased by the 1,000 cash received, while liabilities have increased by 932.3 and shareholders’ equity by 67.7, keeping the balance sheet in balance.

Accounting Treatment at Conversion

Upon conversion, the debt is converted to equity. Therefore, the debt comes down by  as the company no longer owes any money to bondholders  Note that the debt value has increased over its life, since the implied discount on the bond’s issue proceeds has been amortized over its life, so that the bond’s balance sheet value matches its par value on maturity.

Conclusion

Convertible bonds give bond investors protection from   losses (arising from a drop in share prices) by assuring them the par value of the bond. They also give investors an opportunity to gain from any potential upsides in the company’s stock. However, due to the conversion feature, investors will receive a lower coupon on convertible bonds compared to other bond types.

Bond issuing companies pay lower cash interest as compared to regular debt. Convertible bonds help companies minimize equity owner’s discomfort surrounding the issuance of new shares for raising capital. However, the issuance of new shares if the bond is converted is not always received favorably by existing shareholders as it dilutes their ownership and potential returns. With convertible bonds, there is no immediate issuance of new shares. Share dilution happens only if the convertible bond is converted to equity.