Convertible Bonds are bonds issued with the option to exchange the bond for a specific number of shares of common or preferred stock of the bond issuer. This option is generally referred to as a "Conversion Feature."
The Conversion Feature may be either:
- In the money (intrinsic value{}* of the conversion option of the bond is greater than zero)
- Out of the money (intrinsic value of the conversion option is less than zero),
This depends on the market price of the underlying common stock, and the amount of common stock shares the holder is able to convert.
In general, convertible bonds are issued with a coupon rate lower than other bonds, because the convertible bonds also include the accrual of market value of the underlying security as the underlying security's price increases. The convertible bond's market price also includes the intrinsic value of the Conversion Feature. The intrinsic value is determined by calculating the difference between the strike price and the market price of the underlying security. As a result, convertible bonds generally trade at a substantial premium to par. In order to properly calculate the effective yield to maturity and accurately recognize amortization income for convertible bonds, the intrinsic value of the conversion feature must be identified at the time of acquisition.
Intrinsic Value Is defined as the perceived actual value of a security, as opposed to its market price or amortized book cost.
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