Convertible bonds, worked from both sides
A convertible bond is a bond the holder can swap for a fixed number of the issuer's shares. Because of that option, it pays a lower coupon than straight debt, and the conversion price is usually set above today's share price. In our example, a $500 million bond with a 1.5% coupon converts at $40.00 a share into 12.5 million shares, and saves the issuer $22.5 million a year of interest against 6% straight debt. Soreno, an AI voice interview practice app for consulting, investment banking and other finance candidates, runs a free enterprise value calculator with no sign-up, and mock technical interviews where an AI interviewer asks you to treat a convertible in EPS and enterprise value.
Updated
- A bond plus an option. Holders get interest and principal, or shares if the stock rises enough.
- Cheaper interest, possible dilution. The issuer pays a low coupon and may issue shares later.
- Conversion price and ratio. Face value ÷ conversion price = shares per bond.
- US GAAP and IFRS differ. Since ASU 2020-06 most US convertibles are one liability. IFRS splits them.
- Twelve questions below. Short answers in our words and the follow-ups to expect.
A convertible bond in three examples
Larkspur Devices and every number here are invented by Soreno for practice. It issues a $500 million convertible due in 5 years, $1,000 bonds, 1.5% annual coupon, when its stock is $32.00. The conversion price is set 25% above that. It could borrow straight debt at 6%. Tax is 25%. We ignore issuance costs and call features.
Example 1: conversion terms and the payoff25 shares per bond
1. Conversion price
$40.00
$32.00 × (1 + 25%) = $40.00.
2. Conversion ratio
25 shares per bond
$1,000 ÷ $40.00 = 25 shares per bond, $500 million ÷ $40.00 = 12.5 million shares for the whole issue.
3. The interest saved
$22.5 million a year
Coupon 1.5% × $500 million = $7.5 million, against $30 million on straight debt. The issuer saves $22.5 million a year, paid for with the option it gave holders.
4. Holder at maturity, stock low
$1,000 back
At $30.00 the shares from one bond are worth 25 × $30.00 = $750, less than par, so the holder takes the $1,000.
5. Holder at maturity, stock high
$1,400 in shares
At $56.00 the shares are worth 25 × $56.00 = $1,400, so the holder converts. Conversion pays only above $40.00.
Example 2: diluted EPS$2.00 basic, $1.83 diluted
Larkspur earns $200 million on 100 million shares. The stock averaged $50.00 over the year, above the $40.00 conversion price.
1. Basic EPS
$2.00
$200 million ÷ 100 million = $2.00.
2. If-converted
$1.83
Assume conversion: add back the coupon after tax, $7.5 million × (1 − 25%) = $5.63 million, and add 12.5 million shares. (200 + 5.63) ÷ (100 + 12.5) = $1.83.
3. Is it dilutive?
$0.45 a new share
The bond adds $5.63 million of earnings for 12.5 million shares, $0.45 a share, below the $2.00 basic EPS. So it lowers EPS and is included. That test decides it, not the share price: the if-converted shares would count even with the stock below $40.00. If it had raised EPS it would be left out as antidilutive.
4. Principal paid in cash
$1.95
If the terms require the principal in cash, the interest isn't added back, and in our simplified version only the shares for the value above principal count: (12.5 × $50.00 − 500) ÷ $50.00 = 2.5 million. $200 million ÷ 102.5 million = $1.95.
Example 3: US GAAP against IFRS on the books$94.78 million equity component under IFRS
1. US GAAP
One liability, $7.5 million of interest
Since ASU 2020-06, a convertible like this one is a single liability at amortized cost, as long as no other feature must be split out. With no issuance costs, year 1 interest expense is about the $7.5 million coupon.
2. IFRS split
Liability $405.22 million
IAS 32 splits a convertible into a liability and an equity part. Value the liability as straight debt: the $7.5 million coupons and $500 million principal discounted at 6% = $405.22 million.
3. The equity part
$94.78 million
$500 million − $405.22 million = $94.78 million, the value of the conversion option, booked in equity.
4. Interest under IFRS
$24.31 million in year 1
In our simplified version the liability accretes at the 6% rate used to value it: $405.22 million × 6% = $24.31 million, of which $7.5 million is cash and $16.81 million adds to the liability. Over 5 years interest totals $132.28 million, the coupons plus the equity part.
5. The gap
$12.61 million lower net income
Same bond, same cash. IFRS profit is $12.61 million lower after tax in year 1 than US GAAP's, so adjust before comparing an IFRS issuer's interest cover or EPS with a US one's.
From FASB: ASU 2020-06, convertible instruments, IFRS Foundation: IAS 32 Financial Instruments: Presentation and IRS Publication 550, Investment Income and Expenses.
What the interviewer checks on convertibles
In our experience the question tests whether you see both sides: a cheaper bond for the issuer and an option for the holder.
Why issue one
Lower interest now, against possible dilution later at a price above today's.
The terms
Conversion price, ratio and premium, and what the holder gets in each scenario.
Accounting
A US issuer now shows most convertibles as one liability. An IFRS issuer splits them.
12 convertible bond interview questions
The short answers are ours. The note says what a strong answer adds.
The instrument4 questions
What is a convertible bond, and why would a company issue one?
Show follow-ups
Short answer. A bond the holder can turn into a fixed number of shares. The company pays a lower coupon in exchange, and if conversion happens, it issues stock at a price above today's.
Names who issues them: companies with volatile stock or little cash flow to pay high coupons.
How do the conversion price, ratio and premium relate?
Show follow-ups
Short answer. Conversion price = share price at issue × (1 + premium). Ratio = face value ÷ conversion price.
Works one bond through.
Why is the coupon lower than straight debt?
Show follow-ups
Short answer. Holders also get an option on the stock, so they accept less interest.
Says what makes that option more valuable: higher volatility, longer maturity.
Why is debt cheaper than equity?
Show follow-ups
Short answer. Lenders are paid first and interest is tax deductible. A convertible sits between the two.
Places the convertible on that scale. Practice it, see a model answer
EPS and enterprise value4 questions
How does a convertible affect diluted EPS?
Show follow-ups
Short answer. Under the if-converted method, add back the after-tax interest and add the shares, if that lowers EPS. If the principal must be paid in cash, the interest isn't added back.
Checks for antidilution with the per-share test.
How do you calculate diluted shares with the treasury stock method?
Show follow-ups
Short answer. For options and warrants: assume exercise and buy back shares with the proceeds. US GAAP no longer uses it for convertibles in diluted EPS.
Contrasts it with the if-converted method. Practice it, see a model answer
Is a convertible debt or equity in enterprise value?
Show follow-ups
Short answer. Out of the money, debt. In the money, either count its shares and remove it from debt, or keep the principal as debt and count only spread shares if it settles principal in cash.
Warns against counting it twice.
What is the difference between enterprise value and equity value?
Show follow-ups
Short answer. Equity value is the shareholders' stake. Enterprise value adds debt, preferred and noncontrolling interest and takes off cash.
Uses the convertible as the item that can sit on either side. Practice it, see a model answer
In deals and accounting4 questions
Would a buyer rather pay with cash, debt or stock?
Show follow-ups
Short answer. It compares the after-tax cost of each. A convertible is a fourth choice, with a low coupon and possible dilution.
Says when a buyer might fund a deal with one. Practice it, see a model answer
How do you estimate a company's cost of debt?
Show follow-ups
Short answer. From the yield on its traded debt or its rating. A convertible's coupon understates it, since part of the return is the option.
Says to use a straight debt yield in WACC. Practice it, see a model answer
How do US GAAP and IFRS account for convertibles differently?
Show follow-ups
Short answer. Since ASU 2020-06, most US convertibles are one liability at amortized cost. IFRS splits them into a liability and an equity part, so interest expense is higher.
Puts a number on the year 1 gap.
What happens when holders convert?
Show follow-ups
Short answer. The bond comes off the balance sheet and shares are issued. For the holder, the IRS says converting a bond into the same company's stock under its terms generally isn't a recognized gain or loss.
Says what happens to interest expense and the share count.
More to prepare with
Common convertible bond mistakes
Calling the coupon its cost
Larkspur pays 1.5%, but the option it gave away is part of the cost. Straight debt was 6%.
Converting below the conversion price
At $30.00 the shares from a bond are worth $750, below par.
Forgetting the interest add-back
Under the if-converted method, the after-tax interest goes back into earnings, unless the principal must be paid in cash.
Counting it as debt and shares
An in-the-money convertible counted as all its shares leaves the debt line. Otherwise it is counted twice.
Comparing US and IFRS interest directly
In example 3 the same bond costs $7.5 million under US GAAP and $24.31 million under IFRS in year 1.
Explain the convertible out loud
Soreno's AI interviewer asks why a company would issue a convertible, then how it changes EPS and enterprise value. You get a scored report on your answer.
Questions people ask
What is a convertible bond?
A bond the holder can exchange for a set number of the issuer's shares. It pays interest and principal like a bond unless the holder converts.
What did ASU 2020-06 change?
FASB removed certain separation models for convertibles, so a convertible debt instrument is accounted for as a single liability at amortized cost as long as no other feature requires bifurcation. FASB says the interest rate will typically be closer to the coupon. For diluted EPS it requires the if-converted method and drops the treasury stock method for convertibles.
How does IFRS treat a convertible bond?
The IFRS Foundation's summary of IAS 32 says a compound instrument such as a convertible bond is split into equity and liability components, with the equity component measured as the fair value of the whole instrument less the fair value of the liability component.
Is converting a bond into stock taxable for the holder?
IRS Publication 550 says you generally won't have a recognized gain or loss if you convert bonds into stock of the same corporation under a conversion privilege in the bond's terms.
What is a conversion premium?
How far above the share price at issue the conversion price is set. A 25% premium on a $32 stock is a $40 conversion price.
Why do growth companies issue convertibles?
In our experience because their volatile stock makes the conversion option valuable, which lets them borrow at a low coupon without a large cash interest bill.