What is the Conversion Ratio?
The Conversion Ratio refers to the number of shares of common stock that a convertible security holder is entitled to receive after exercising an embedded option.
Convertible bonds combine the features of common stock and corporate bonds into a hybrid security by offering the bondholder an embedded option that grants the holder the right to convert (or exchange) the par value of the bond for a set number of common shares.
The debt component of convertible bonds mandates the underlying corporate issuer to pay periodic interest and the par value at maturity, whereas the equity component provides the bondholder with the option to exchange the securities for a predetermined number of shares of equity, at their discretion.
How the Conversion Ratio Works for Convertible Securities
The conversion ratio establishes the number of shares of common stock for which a convertible security can be exchanged.
Convertible securities are a form of specialized financing structured with an embedded option, whereby the holder has the right to exchange the securities for a set number of shares in the common stock of the underlying issuer.
In practice, convertible bonds and preferred stock are two types of convertible securities issued by corporations to raise capital from investors.
- Convertible Bonds → Convertible bonds entitle their holders to receive periodic coupon payments at predefined intervals (i.e. interest), similar to traditional corporate bond issuances. The distinction is that convertible bonds, as implied by the name, come with an embedded conversion feature.
- Preferred Stock → Preferred stock issuances grant stockholders with a preference dividend, most often in proportion to the original issuance price. Compared to common shareholders, preferred stockholders possess a higher claim on the earnings of the issuer (or its assets in the event of liquidation). Like debt, preference shares come with no voting rights.
The embedded conversion option provides the bondholder or preferred stockholder with the option to convert their securities into shares in the issuer’s common stock, if the necessary conditions are met.
The conversion ratio denotes the specific number of shares in common stock that an investor can receive upon exercising the embedded option of a convertible security.
On that note, the higher the conversion ratio, the more shares (and greater value) are earned by redeeming the embedded option.
Since risk and return are inversely related, the conversion ratio thereby reflects the riskiness of the embedded option, where more risk attributable to the issuer means more shares are necessary for the incentive to be sufficient.
Embedded Option for Convertible Bonds
The parameters set around the conversion option can vary widely per issuance.
The terms can be found on the prospectus (or the relevant documentation) to formalize the agreement between the two parties.
For instance, certain convertible securities are issued with provisions that prohibit the holder from redeeming the conversion feature for a predefined period.
On the other hand, the embedded feature can be mandatory, rather than optional, for other convertible securities (i.e. call or put provisions).
Note: The conversion ratio is adjusted if the corporate issuer undergoes a stock split, reverse stock split, or corporate action where the share count is adjusted upon completion.
How to Calculate Conversion Ratio for Convertible Bonds
The specific terms stated on the formal agreement for the convertible security are therefore the core driver of returns (and source of risk) to the corporate issuer and investor.
There are three variables in particular that must be understood to grasp the basic mechanism of a convertible security.
- Par Value → The par value, or “face value”, is the original price of the security on the date of issuance, which is set at $1,000 (or “100”) for most corporate bonds.
- Conversion Price → The conversion price equals the par value of the convertible security divided by the conversion ratio. Conceptually, the conversion price is the “minimum hurdle” that the stock price of the issuer must reach (and exceed) for the embedded conversion feature to be exercisable.
- Conversion Ratio → The conversion ratio specifies the number of shares in common stock collected if the embedded option is redeemed.
Given the embedded feature to convert the security into common stock, the potential upside on the yield of a convertible bond is higher because the holder is presented with the option to become a common shareholder and profit from the positive share price movement in the issuer’s common stock.
But for the same reason, a convertible bond is priced at a lower coupon rate relative to a comparable corporate bond with no embedded option, barring extraordinary circumstances.
The intrinsic value of a convertible bond is the number of converted shares at its par value multiplied by the current market price of common shares (and should not drop below the market price, in theory).
- In-the-Money (ITM) → Conversion Price < Stock Price
- At-the-Money (ATM) → Conversion Price = Stock Price
- Out-the-Money (OTM) → Conversion Price > Stock Price
Basic Properties of Convertible Bonds (Source: UBS Asset Management)
Conversion Ratio Formula
The conversion ratio is specified in the formal agreement between the issuer and the investor (or bondholder), along with the other lending terms or clauses.
However, calculating the conversion ratio is seldom performed on the job because the ratio is predefined on the contractual agreement (i.e. it is readily observable).
The conversion price and conversion value are calculated instead, since the former determines the minimum stock price while the latter is the if-converted pay-off value.
The conversion price is determined by dividing the par value of the convertible security by the conversion ratio.
Technically, the conversion ratio can be solved for by re-arranging the formula, where the par value is divided by the conversion price.
But the more practical measure is the conversion value, which is calculated by multiplying the conversion ratio by the current market price of the issuer’s common stock.
Where:
- Conversion Ratio → Number of Shares in Common Stock per Convertible Bond
- Market Price → Market Value per Share of Common Stock
Conversion Ratio Calculator
We’ll now move on to a modeling exercise, which you can access by filling out the form below.
1. Bond Convertible Ratio Example
Suppose a publicly-traded company decides to raise capital in the credit markets by issuing a 10-year convertible bond (Year 0).
The par value of the convertible bond is $1,000 bond priced at a fixed coupon rate of 8% on the date of issuance.
- Par Value of Convertible Bond = $1,000 (“100”)
- Coupon Rate (%) = 5.0%
The conversion ratio, per the prospectus of the convertible bond issuance, is 4:1, so the bondholder is entitled to retrieve four shares in common stock per conversion.
- Conversion Ratio = 4:1
2. Bond Conversion Price Calculation Example
Given the conversion ratio, the conversion price – the minimum price at which the bond can be converted into common shares – is determined as $250 per share
- Conversion Price = $1,000 ÷ 4:1 = $250
The embedded option feature cannot be exercised unless the stock price exceeds $250.
The stock price of the issuer, or market price, will be assumed to be $300 per share, so there is a delta of $50 compared to the conversion price.
- Market Price = $300
- Conversion Premium = $300 – $250 = $50
2. Conversion Value Calculation Example
The conversion value is calculated as the product of the conversion ratio and the market price of the issuer’s common stock.
Upon multiplying the conversion ratio by the market price per share, we estimate the convertible value – the value of the common shares received post-conversion – to be $1,200 per bond.
- Conversion Value = 4:1 × $300 = $1,200
The conversion value exceeds the par value of the convertible bond on the date of issuance (and thus, profitable to convert).
Hence, there is the necessity for the corporate issuer to set parameters to ensure there is sufficient time for the capital raised to be reinvested into operations or purchase fixed assets (Capex).
Because of the standard non-callable period by which the embedded conversion option cannot be exercised, the market value of the convertible bond is used for comparability going-forward (market price vs. conversion price).
The concept illustrated here was the relationship between the conversion price, market price, and conversion value, including the importance of setting the conversion ratio appropriately for the security to not be in-the-money (ITM) too quickly.
To further mitigate the aforementioned risk, timing constraints pertaining to the call and put features are needed to further protect the downside risk, for both sides.
Since the cash flow is on a pro forma basis, the forecasted cash flows earned on the convertible bond, such as the coupon payments and retrieval of the original principal, must be discounted to their present value (PV).
How Does Conversion Ratio Impact Conversion Value?
The option to participate in the equity upside is coupled with the typical downside protection of fixed income instruments, similar that of corporate bonds.
If the decision to convert is not economically feasible, the bondholder can decide to not exercise the embedded option and instead hold the security until the date of maturity.
The holder of a convertible bond – assuming a traditional financing arrangement (i.e. a non-complex embedded option) – can decide to convert the investment into shares of common stock or receive the par value at maturity with periodic interest collected over the borrowing period.
The minimum value of a convertible bond is the greater value between the two metrics:
- Conversion Value (Post-Conversion Equity Value of Shares)
- Value of Corporate Bond (without Embedded Conversion Option)
Based on the expected share price performance of the underlying issuer, the capital allocation decision boils down to comparing the return earned from the conversion value to the yield earned on the bond without the embedded conversion option.
The potential to earn an outsized return and the additional downside protection offered to the investor comes at a price, of course, which is a lower cost of capital (i.e. a “cheaper” source of funding for the corporate issuer).
The conversion ratio is inherently tied to the risk profile of the issuer, so more risk warrants a higher conversion ratio, since incremental risk must be compensated with a greater return.
What Factors Affect the Conversion Value?
So, why do corporations issue convertible securities in the first place?
In short, the underlying corporation that issues the convertible securities can raise capital at a lower cost, such as reduced pricing on the interest rate of a bond.
The trade-off between risk and return can often be worthwhile for both parties (i.e. aligned interests), since convertible securities are only redeemed if the decision is deemed profitable.
If the embedded option is exercised, that implies the share price of the issuer increased post-issuance (i.e. the bondholder decided the return on common equity exceeds the yield on the bond).
Considering the conversion ratio dictates the potential upside in the return on a convertible security, investors (and the issuer) must pay close attention to ensure the risk-return trade-off is a sound decision.
The factors that form the basis for the negotiated terms are as follows:
- Historical Stock Price Performance → The historical share price movement and near-term outlook on the Company’s future trajectory (or perhaps long-term, depending on the terms of the agreement) are two of the main factors that impact the conversion ratio.
- Recent Operating Performance → In particular, the recent volatility in the company’s stock price (and the underlying causes) are closely analyzed since recent performance tends to serve as a more accurate proxy for near-term performance (“back-weighted”).
- Credit Risk Profile → The creditworthiness of the issuer (i.e. credit rating and risk of default), current interest rate environment, and economic conditions are a couple more factors that can influence the conversion ratio.
- Dilutive Impact on Common Stock → The most notable risk considered by the issuer and its shareholder base is the dilutive impact on the existing common equity ownership post-conversion of such securities (i.e. the increase in share count causes the equity value per share to decline in proportion).
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