Strategic Advantages of Convertible Securities

The advantages to a corporation of issuing convertible securities are as follows:

• Lower Interest Rates: The interest rate is typically lower than on a straight debt issue.
• Capital Market Access: This type of security may be the only device for allowing a small firm access to the capital markets.
• Optimized Stock Sales: The convertible allows the firm to effectively sell stock at a higher price than that possible when the bond was initially issued (though perhaps at a lower price than future price potential might provide).

Investor Incentives and Market Premiums

Investors are willing to pay a premium over the theoretical value for a convertible bond issue because of the future prospects for the associated common stock. Thus, if there are many years remaining for the conversion privilege, the investor will be able to receive a reasonably high interest rate and still have the existing option of converting to common stock if circumstances justify.

Determining the Floor Price

The floor price of a convertible is based on the pure bond value associated with the interest payments on the bond, as shown in Figure 19-1. Regardless of how low the associated common stock might go, the semiannual interest payments will set a floor price for the bond (S-85).

Convertible Bond Pricing Analysis

• Gordon Bonds: These are priced well above par value because the common stock has probably increased substantially.
• Marshall Corporation: In this case, it is reasonable to assume that the common stock has declined. Additionally, its interest rate is likely well below the going market rate because of its low bond price.
• Market Impact: With the Gordon Corporation, there would be little or no impact, as it is clearly controlled by its common stock value. With the Marshall Corporation, its potential value is somewhat associated with interest rates (rather than just conversion), so it is likely to go up somewhat in value.

Forced Conversion via Call Privileges

A firm may force conversion of a bond issue through the use of the call privilege. If a bond has had a substantial gain in value due to an increase in the price of the underlying common stock, the bondholder may prefer to convert to common stock rather than trade in the bond at some small premium over par, as stipulated in a call agreement.