Analysis of Convertible Bonds

With the repeal of the Capital Issues Control Act and the enactment of SEBI Act in 1992, the rules of the game applicable to convertible bonds have changed. As per SEBI guidelines issued in June 1992, the provisions applicable to fully convertible bonds and partially convertible binds are as follows:

* The conversion premium and the conversion timing shall be predetermined and stated in the prospectus.
* Any conversion partial or full will be optional at the hands of the bond holder, if the conversion takes place at or after 18 months but before 36 months from the date of allotment.
* A conversion period of more than 36 moths will not be permitted unless conversion is made optional with ‘put’ and ‘call’ options
* Compulsory credit rating will be required if the conversion period for fully convertible bonds exceeds 18 months.

From the SEBI guidelines it is clear that convertible bonds in India presently can be of three types:

(a) Compulsorily convertible bonds which provide for conversion within 18 months.
(b) Optionally convertible bonds which provide for conversion within 36 months.
(c) Bonds which provide for conversion after 36 moths but which carry ‘call’ and ‘put’ features.

My guess is that the bulk of the convertible bonds in the immediate future will be of types (a) and (b). Hence, our discussion on valuation of convertible bonds will focus on these two types.

Valuation of Compulsorily Convertible (Partly or Fully) bonds

If you own a compulsory convertible (partly or fully) bond you receive:
* A certain number of equity shares on part /full conversion
* A certain stream of interest and principal repayments.
Hence the value of such a bond is equal it the sum of two components:
* The present value of equity shares receivable on conversion
* The present value of interest and principal payments receivable on the bond

Valuation of optionally Convertible Bonds:

An optionally convertible bond may be viewed as a bond warrant package. Its value is a function of three factors:

(1) Straight bond value
(2) Conversion value
(3) Option value

Straight Bond value: The straight bond value of a convertible bond is the discounted value of the interest and principal repayments receivable on it, if it is retained as a straight debt instrument. The discount rate used in this calculation depends on the general rates and the credit rating of the bond.

The value of straight bond depends on the value of the firm. If a firm’s value declines, the value of its straight bond may fall. In the extreme, if the value of a firm shrinks to zero, the value of its straight bonds becomes nil. The maximum value of a firm’s straight bond would be equal to the value of an equivalent risk free bond.

Conversion Value: The conversion value is the value of the bond if the bond holders seek conversion. It is equal to the stock price multiplied by the conversion rate. Thus the conversion value is linearly related to the value of the firm as shown.

We have defined the straight bond value and the conversion value of a convertible bond. The value of convertible bond theoretically cannot fall below its straight bond value as well as its conversion value. Put differently, the convertible bond has two floor values: its straight bond value and its conversion value.

Option Value: In a convertible bond you are not compelled to make an immediate choice in favor of or against conversion. You can wait, learn from hindsight and finally choose the most profitable alternative. The option to wait is valuable. Hence, the value of the convertible bond lies above its floor value.

Value of the convertible bond = Max (Straight bond value, Conversion value) + Option value