Conversion premium is the term used in the financial market in connection with convertible securities. Thus, to understand the conversion premium, the reader should have a clear concept of convertible securities.
Convertible securities
As the name suggests, conversion securities are the select type of securities, “which are convertible into something else.” What that “something else” usually is? It is “Common Stock.”
Thus, whenever there are convertible bonds, it would mean that bonds are convertible into new common stock at a future time.
A Convertible Bond (CB) is a corporate bond debt security that gives the holder the right to exchange future coupon payments and principal repayments for a prescribed number of equity shares.
Thus, it has both equity part and fixed income part, and may contain some additional features, such as callability and portability.
Conversion price
Convertible securities are converted to a fixed number of common stocks. These common stocks are valued at a nominal price per share.
This price and quantity are set at the time of issuance but could be adjusted as described in the issuance prospectus.
Conversion premium
The excess of the amount at which a convertible security may be sold over its conversion price is known as conversion premium. If the market price of convertible security rises, its conversion premium will decline.
For example, a bond valuing $1000 is convertible into 50 common stocks. The market value of common stock today is $15 each, so there is conversion premium of $250 {(50 x $25)- $1000}.
If the value of the premium is negative, the holder won’t sell securities. Instead, he will get them redeemed at par value.
Understanding the Conversion Premium
Where a company is in need to finance any of its projects externally, it would have two options, i.e., either to borrow it from a bank or to borrow from the public.
Convertible Bonds are issued by a company to raise cheap funds. Funds raised by convertible bonds are less expensive than borrowing from banks.
Offering investors to pay the regular interest along with the option to convert it later to shares is attractive, thus allowing the company to manage the deal with a lower interest rate.
Sometimes, issuing convertible bonds might be the only option when the company is just starting up and is young. There is a possible incentive of cash flow savings for the company if the bonds get converted to common stock.
The company would pay interest on those bonds, and like any other debt instrument, convertible bonds will have a maturity date.
Unlike any other bond, the holder of that bond will have the right to exchange that bond, on or before the maturity date, for a predetermined number of common stocks at a conversion price.
Example:
Let’s say Apple Inc issues convertible bond at a value of $800. The prospectus states that the bond is convertible into 40 common stock. Here implied conversion price is $20 per share ($800 / 40).
For holders, there needs to be some reasons to buy these bonds. For them, convertible bonds provide an easy exit route for early-stage funding of a startup.
It offers potential for a future advantage on conversion if a company’s business takes off and share price increase in the stock market.
The investor would know that if things go wrong, by holding that bond would have protection from downside or decrease in price, as bonds would be redeemed at par value.
Example:
As stated in the previous example, Mr. Alex has bought bonds issued by Apple Inc. The implied conversion price was $20.
If the stock market’s current share price is $15 per share, then the conversion premium is $5 per share ($20 – $15) or 33%.
Interpretation of Conversion Premium
As in the above example, conversion premium is 33%, current share price needs to rise 33% before holders of convertible bonds would start considering converting it.
At the moment, it is better for them to hold convertible bonds and to redeem them rather than to convert.
A significant premium makes conversion less likely and means the convertible will behave like a bond than a share.
The premium on the issue may be as much as 25-40%. The premium on the issue is high because the company is trying to take off.
As the business grows and the business model starts to become a success, the market value of the share would rise to make conversion premium less.
| Where Conversion Premium is Negative | ||||||
| Convert to Shares | Accept | |||||
| Convertible Bonds | Conversion Date | |||||
| Redeem | Reject | |||||
| Where Conversion Premium is Positive and High | ||||||
| Convert to Shares | Reject | |||||
| Convertible Bonds | Conversion Date | |||||
| Redeem | Accept |
How Issuer Uses Conversion Premium?
A study of the U.S. convertible debt market was conducted, which suggested that issuing companies try to achieve optimized the structure of hybrid financing by setting the parameters of convertible bonds.
Statistical correlations between the conversion ratio, conversion premium, and conversion period were observed. The conversion ratio was high when a company was high-valued, and the conversion premium was negative.
When the conversion premium increased, the conversion ratio decreased. Moreover, the higher the ratio, the more extended the conversion period can be observed. The conversion premium on the day of issuance is determined by convertible debt maturity.
Despite statistical differences in observed relationships, their directions were consistent with theoretical expectations.
Fixed assets act as security and protect lenders and investors of the company. If their value in relation to new debt is reduced, the issuer’s financial risk of insolvency increases.
For the issuance of convertible bonds to be successful, this financial risk must be compensated by additional benefits to investors.
One of them may be a more extended conversion period, which increases the probability of conversion and the expected rate of return from the investment. According to other findings, it may be achieved by a higher conversion premium.
Finally, a higher conversion ratio can be applied. The higher conversion ratio will increase the equity to debt ratio and lower financial risk.
