A convertible bond is a security issued by a company for thepurposes of borrowing money. In addition to the usual features of a bond(coupon rate, payment interval, face value, maturity date), a convertible bondhas been endowed with the added benefit of being converted into common(sometimes preferred) stock. This leads to new features which the buyer must bewell aware of before buying this instrument.First is the conversion price; this is the price at which aconvertible bond can be converted into stock. The conversion price goes hand inhand with the conversion ratio which is simply calculated as the face value ofthe bond divided by the conversion price. To go a step further, we candetermine the value of doing a conversion simply by multiplying the conversionratio by the current stock price.If that result is greater than the amount paid for the bond,then the bond is said to be ‘in-the-money’ (same expression and sentiment as inthe options world).
When a convertible bond is in-the-money, a certain part ofits trading price is derived from this fact. That amount is referred to the conversionpremium and is obviously exclusive to convertible bonds.Obviously, a portion of the bond’s value remains fixed; thisis the traditional value derived from face value and coupon rate and is typicallycalled investment value or bond value.
This is sometimes also referred to asthe floor value, since the bond should never trade below this value. Theconversion option on the bond is exactly that, an option, so the minimum valueof it is 0. If the option part of the bond is worthless, (unlikely since thereshould be some time value, unless we are very close to maturity) it still hasthe value equivalent to any other bond of equal credit rating paying thatcoupon and face value.
For that reason we state again that a convertible cannever trade below its bond value.