December 6th, 2013 by

If you’ve ever come across the term ‘convertible bond” and been perplexed by it, don’t feel badly.  I didn’t have a clue as to what they were until many years into my investing life.  They are a very intriguing asset class deserving of attention for your long term bond portfolio.

To see a list of high yielding CDs go here.

The basic definition is that this is a bond that can be converted into a given amount of the company’s equity at specific trigger points, and often at the discretion of the bondholder.  There are several terms usually associated with convertibles.

The first is the conversion rate of the bond.  This means the number of shares that the bond can be converted into, usually expressed as number of shares per \$1,000.  The bondholder is provided this information in the prospectus and is almost always done at a rate that will be fixed.  However, sometimes the amount of shares can vary based on various conditions, so it’s important to carefully read the prospectus to know when and for how much you can trigger the conversion.

Then there is the conversion price.  This is determined by dividing \$1,000 by the number of shares you get per \$1,000 conversion.  So if you are going to receive 50 shares, then the conversion price is \$1,000 / \$50 = \$20 per common share.

Then we have intrinsic value.  That’s the conversion rate multiplied by the current price of the stock.  So in this example, if the stock were at \$15 per share, the intrinsic value is 15 x 25 = \$375.

How do these terms play out in a real convertible offering?  I’ll explain in a moment with a real example, but first you should understand the reasons for a convertible bond offering.  A company will often do this to lower the coupon rate when it issues debt.    Because you get the right to convert that bond into equity, you get a lower interest payment in exchange.  This saves the company interest expense.   It also allows a company to raise capital without immediately diluting shareholders.  Dilution gets delayed.  So the investor is effectively getting a stock option tucked within a bond.  If the stock continues to do well, the bondholder would convert the bond into equity above that conversion price.  They get the equity upside while having collected a little interest in the interim.  Also, convertible bonds sit ahead of common shareholders in the event of a bankruptcy or dividend suspension.

In August, Portfolio Recovery Associates (PRAA) issues \$250 million of 3% convertible notes due in 2020.   The conversation rate was 15.2172 shares per \$1,000 principal, which is equivalent to an initial conversion price of \$65.72.  PRAA added a kicker, in that the conversion can be paid in stock or cash or a combination.  PRAA does not have the right to redeem the notes prior to maturity, and so the bondholder has a nice advantage.

At the time of the issuance, PRAA was trading at \$50.   Now it’s at \$58, and had gotten as high as \$62.  So bondholders have seven years for the stock to go above \$65.72 if they want to convert.  I suspect that will happen.  PRAA is growing very strongly, and the company needed the capital to purchase consumer debt on the cheap, which it then turns around and collects in multiple of what it paid for.  This is why knowing the company and what it does give you an advantage in purchasing convertibles.