Convertible Corporate Bonds - Convertible Debentures

Some of the math - formula questions on the Series 7 and that you will need to study a little on is convertible corporate bonds. These are bonds that can be converted into common stock of the issuing corporation at a set conversion price. The exam will have you do some calculations and present scenarios.

Debentures

Corporate debt that is backed by the full faith and credit of the issuing company are known as debentures. Corporate debentures are rated by companies for credit quality. You can buy investment grade or speculative bonds.

Secured corporate bonds are backed by an asset or collateral. When a bond is secured, it is backed by collateral. That collateral could be cash, securities, real estate or equipment.

Corporate bonds can be callable by the issuer. Call dates can be placed on the bond and this allows the company to redeem the bonds early beginning on set dates and at set redemption prices. This is normally not a good feature for investors, because an issue is normally called when interest rates are low - lower than your coupon rate. The main reason debentures or bonds in general are called, is because the issuer wants to refinance their debt at a lower rate. When this happens, the investor is faced with having his money (par) returned early, but the higher paying bond is no more. To make matters worse, interest rates are lower in the market, so finding a suitable replacement will be difficult, if not impossible. Callable bonds to pay a higher yield though, so for some the risk is worth it.

Convertible

Some bonds issued by corporations are convertible into common stock of the issuing company. This conversion feature acts as an incentive for the bondholder. The company is hoping the investor eventually converts into the common stock of the company. The investor finds convertible corporate issues attractive, because they have an option to buy stock in the company at a fixed conversion price.

Converting a bond is based on par value and the fixed conversion price that appears on the bond. The conversion price is not the price the stock is purchased at. So, it is unlike a "Stock Option". The time to convert is the investor's choice. An example:

A customer owns ABC convertible bond that is selling in the market at $1040 or $104, the common stock is selling at $54 and the conversion price is $50. The investor would like to convert, but will only do so when the stock value is trading above the bond value. "Parity" would occur when the bond and stock are equal. The first thing you must find out is the amount of shares the customer is entitled to. We get that by dividing the conversion price into the par value of the bond ($1000). $1000 divided by 50 equally 20.

The investor can convert out of the bond into 20 shares of stock - no more no less. The stock is currently trading at $54, so the the stock value is found by multiplying 20 (shares) by $54 (stock value), which equals $1080. $1080 is above the bond selling price of $1040, so converting at this time would meet the customer's objectives of converting only when the stock value was above bond value or "above parity".

Series 7 Full Study Prep!