Understanding Convertible Bond Valuation vs. Traditional Bonds

Convertible bonds are corporate bonds that owe their name to the fact that they have the potential to be converted into common stock of the issuing company. Compared to traditional bonds, convertible bonds are more sensitive to company-specific news and less sensitive to systematic economic conditions. Consequently, their valuations must consider the same factors as their equity counterparts, because they may one day become those very same equities themselves.

It should be noted that the equity conversion option acts like a call option for the underlying company’s stock. And like call options, value changes based on the variance in underlying stock price, conversion ratio, interest rates, and the maturity of the option instrument.

Understanding the Role of Valuations

The financial term “valuation” refers to a process of determining a financial asset’s fair value. Nearly all valuation models seek to determine the present value of an asset’s expected future cash flows.

With traditional bonds, which boast fixed maturity dates and contractually locked in payouts, this calculation process is straightforward. But determining this metric can become thornier for convertible bonds because the potential post-conversion price of the resulting equity is intrinsically harder to predict.

How Traditional Bonds Are Valued

Traditional bond valuation involves the following three steps:

1. Estimating the expected future cash flows
2. Determining a reasonable discount rate for future cash flows
3. Applying the discount rates to the expected future cash flows, in order to arrive at a present value

Future cash flows should be equal to the yet-unpaid coupons left before maturity plus the face value of the bond at maturity. Discount rates cannot be set as neatly; they must be adjusted as current yields adjust.

The relationship between bond value and discount rates is the same as the relationship between bond prices and yields. The lower the discount rate is, the higher the value of the bond becomes. Conversely, the higher the discount rate is, the lower the value of the bond becomes.

Evaluating Convertible Bonds

Convertible bonds have an embedded ability to be converted into stocks. This is sometimes referred to as the “equity participation feature.” There are multiple methods for valuing convertible bonds. Some are relatively simple, while others are substantially more involved, especially the ones that attempt to determine the conversion premium per share.

Furthermore, investors should anticipate how the impact of interest rates on stock prices could ultimately affect convertible values.

To accomplish convertible bond valuations, investors may rely on the following formula: