What Is a Conversion Premium?
A conversion premium is an amount by which the price of a convertible security exceeds the current market value of the common stock into which it may be converted. A conversion premium is expressed as a dollar amount and represents the difference between the price of the convertible and the greater of the conversion or straight bond value.
- A conversion premium is added value that a convertible security possesses due to its conversion option.
- The reason for the premium is that once converted, the investor will own a greater value in equity shares than previously owned in bonds.
- Convertible arbitrage strategies are used by some traders to take advantage of excess conversion premiums in the market.
- The conversion premium is a key component of computing a convertible's payback period.
Understanding a Conversion Premium
Convertibles are securities, such as bonds and preferred shares, that can be exchanged for a specified number of common shares at an agreed-upon price. When convertible bonds mature, they can be redeemed at their face value or at the market value of the underlying common shares, whichever is higher. Convertibles can be converted at the option of the investor, or the issuing company can force the conversion.
Convertible bonds, for example, are unsecured debt securities that can be converted into common stock of the corporate issuer within a specified time period at the discretion of the bondholder. The trust indenture of the bond specifies the conversion ratio, that is, the number of shares that each bond held can be converted into. If the conversion ratio is 40, or 40 to 1, then each bond with a par value of $1,000 can be converted into 40 shares of the issuing company.
The conversion feature in the trust indenture may also be expressed as a conversion price, which is equal to the face value of the bond divided by the conversion ratio. If the share price is stated as $25, then the conversion ratio can be found to be $1,000 par value/$25 = 40 shares.
Once a bond is issued, the amount by which its price exceeds the conversion price is referred to as the conversion premium. The conversion premium compares the current market against the higher of the conversion value or straight-bond value. The straight-bond value is the value of the convertible if it did not have the conversion option. The conversion value, on the other hand, is equal to the conversion ratio multiplied by the common stock's market price.
For example, if a company issues a convertible bond that can be exchanged in the future for 50 shares of common stock and the common stock is currently valued at $20 per share, the conversion value is $1,000 = 50 shares X $20. The conversion premium is the premium the bondholder will have over the conversion value. If the bond is currently selling for $1,200, then the conversion premium can be calculated as $1,200 - $1,000 = $200.
Conversion Premia and Payback
The conversion premium is used to calculate the bond’s payback period, that is, the amount of time it would take for the bond to earn the conversion premium plus all stock dividends over the period. The cash-flow payback period is the time it would take for the convertible to earn interest equal to the conversion premium plus the stock dividends if the number of shares specified in the conversion ratio was purchased instead of the convertible. The formula for the cash-flow payback period is:
Cash-Flow Payback Period = [Conversion Premium / (1 + Conversion Premium)] / [Current Yield - Dividend Yield / (1 + Conversion Premium)]