Convertible Bond Crash Course: Accounting, Valuation, WACC, and More

You'll learn all about convertible bonds in this tutorial, from accounting and valuation to the "Cost of Convertible Bond" calculation. For the written guide and Excel files, please see the links below the Table of Contents:
Table of Contents:
0:00 Introduction
2:20 Part 1: Typical Terms and Conversion Options
5:23 Part 2: Which Companies Issue Convertible Bonds?
9:25 Part 3: Convertible Bonds on the Financial Statements
16:00 Part 4: Convertible Bond Valuation & Black-Scholes
20:01 Part 5: Payoff Diagrams and Payback Periods
24:01 Part 6: Blended Cost of Convertible Bonds
29:05 Recap and Summary
Files & Resources:
youtube-breakingintowallstree...
youtube-breakingintowallstree...
KEY POINTS:
To analyze and value convertible bonds, you must split them into their Liability and Equity components.
People often claim that convertible bonds are "cheaper" than traditional bonds that cannot convert into shares, but this is not true.
Their cash cost is lower because the coupon rates on convertible bonds are lower, but the "all-in cost" - factoring in their potential to convert into shares - makes them more expensive than traditional debt.
You can estimate the # of shares a convertible may convert into by calculating the Conversion Ratio, or Par Value / Conversion Price, and multiplying it by the # of Convertible Bonds, or Bond Principal / Par Value.
To simplify, it's just Bond Principal / Conversion Price.
On the financial statements, a convertible bond may be recorded as a single liability (most common under U.S. GAAP) or split into liability and equity components (more common under IFRS).
The "single liability" treatment means the company will only record the cash interest on the bond and the issuance fee amortization for the interest expense.
With the "split" treatment, the company records the amortization of the bond discount as well, which is based on the equity component / term of the bond; this greatly increases the interest expense but is mostly non-cash.
Convertible bonds are issued most often by high-growth, speculative companies because they act as "hedged equity" for investors. If the company performs well, they capture the equity upside, and if not, they at least get their money back when the bond matures.
To value a convertible bond, you can use the PRICE function in Excel for the liability component, and for the equity component, you can use Black-Scholes to value each call option in the issuance and sum them up.
The more volatile the company's stock and the closer its current share price and the Conversion Price, the more valuable the convertible bond is.
You can also create "payoff diagrams" that show the convertible bond's value or market price vs. its payoff value, or what bondholders earn at different share prices.
Because of the downside protection and the potential equity upside, convertible bonds are worth more than their payoff values even when the share price is below the Conversion Price, and they remain that way above the Conversion Price.
You can calculate the "Blended Cost" of a convertible bond by separating it into liability and equity components, taking a weighted average, and using some option math to estimate the Cost of the Conversion Option, which equals Risk-Free Rate + Equity Risk Premium * Option Beta.
The "Option Beta" is usually much higher than the company's Levered or Relevered Beta because the option's price is much more sensitive to changes in the underlying stock price.
As the company's stock price increases, the Cost of the Convertible Bond moves closer to the Cost of Equity; as the stock price decreases, the Cost of the Convertible Bond moves closer to the After-Tax Cost of Debt.
You can use these types of metrics and analyses to determine how appealing a convertible bond issuance will be to investors, how it should be marketed, and if any of the terms should change.

[@financialmodeling]

Files & Resources: youtube-breakingintowallstreet-com.s3.amazonaws.com/Convertible-Bond-Valuation-Analysis.xlsx youtube-breakingintowallstreet-com.s3.amazonaws.com/Convertible-Bond-Valuation-Analysis-Slides.pdf The Table of Contents and written summary are in the video description above if you click "more" next to the title.

[@theseismicwavesmongolia7720]

Absolutely love this video! Would love if you could talk more about Convert Arb stuff in the future. Love ur videos and thank you very much

[@financialmodeling]

Thanks, I'll see what we can do for more convertible-related topics.

[@punkyhippo]

This is such a well packaged video. I don’t often comment on channels, but I have to say, I haven’t found anything around as concise and clear on the topic of convertible bonds, specifically their valuation and factoring into the cost of capital, as this video. Well done, congratulations on deconstructing a complex topic with such ease. I am curious though, most convertible bonds are callable by the issuer, so how would convertibility factor into the valuation formula if the bond was callable? Say, in your example, after two years? Also, if it was callable at any time after two years (like an American option) or at every 6 month interval (like a European option) until maturity?

[@financialmodeling]

Thanks! Callability is a complex topic that we didn't have time to get into here, but in short, you would have to come up with some type of decision/probability tree and look at the callable dates and assign a probability to the call happening on each one. This gets very complex/time-consuming and is not something that most bankers or even convertible bond investors do frequently (there may be automated approaches to simulate it, though). In general, this will tend to reduce the value of convertible bonds and make them more like traditional debt because if a company can call the bond on certain dates or intervals, it reduces the probability of a conversion into equity. You might be able to simulate this by using shorter periods in Black-Scholes and doing some type of weighted average over time based on the call dates.

[@monafadlalla]

Do the non-convertible bonds (used for the equivalent rate on non-convertible bonds) also need to be non-callable?

[@financialmodeling]

They should be as close as possible in terms of other features, but if you can't find anything close that's also non-callable, it's fine.

[@lelioshmelio]

Hi! What do you mean as "Bond Discount" when calculating total interest expense?

[@financialmodeling]

This "bond discount" happens most often under IFRS because there, most convertible bonds are split into liability and equity components. The liability starts out at less than the face value, and the amortization of the bond discount boosts it each year until it reaches the face value by the maturity. The amortization is counted as a non-cash interest expense on the Income Statement.

[@lelioshmelio]

@@financialmodeling thank you!

[@baptiste270399]

You used the historical vol to price the convertible, can we/Should we use the implied vol instead? What is the market practice ?

[@financialmodeling]

You can do that, yes, assuming you have access to the data (forward/implied numbers are better if available). We assumed no Bloomberg/FactSet/other data access here, so the historical volatility was easier to retrieve.

[@shivanshshukla5883]

If I am in India would modelling be different for me as we follow Ind AS which is 80% similar to US GAAP, would I have a problem if I buy your package.

[@financialmodeling]

We cover both U.S. GAAP and IFRS and feature case studies from companies worldwide. So if Indian accounting rules are very similar to U.S. GAAP, the courses should be fine.

[@shivanshshukla5883]

@@devm.9189 do we know each other?

[@eugene7678]

Why do we translate nominal value into shares and not book or market value ?

[@financialmodeling]

Market value isn't relevant because it mostly reflects changes in interest rates and credit quality, and these do not impact the shares a convertible bond converts into. Book value is not relevant because it deducts unamortized issuance fees (which also do not affect the shares) and may deduct the convertible bond discount (more common under IFRS now). And this discount also doesn't change the shares it converts into.

[@1minute903]

Always good content. But , sometimes i feel , that your videos sometimes becomes lengthy or become difficult to keep track of. It requires person to have expertg knowledgealready to understand the content.

[@financialmodeling]

Thanks. Unfortunately, there's only so much we can do to simplify/shorten these "crash course" topics. A 30-minute video may seem long, but it's much faster to get through than a 500-page textbook or long and detailed written chapters on the same topic.