Callable and convertible features

Two options, two owners

A call feature lets the issuer repay a bond before maturity at a stated call price, usually par or a little above, and usually only after a period of call protection. It exists for the same reason a homeowner refinances: if rates fall, the issuer can retire the old high-coupon debt and borrow again at today’s lower rate. The issuer uses the option exactly when it hurts the holder.

That harm has a name — call risk. The holder loses a high coupon at the moment reinvestment rates are low, and the bond’s price stops rising once it nears the call price, because nobody pays $1,150 for a bond that may be redeemed at $1,030 next month. The market charges for this: callable bonds often offer a higher yield than otherwise identical non-callable bonds, and the call price may include a premium.

Callable bonds add one more yield. Yield to call is worked out like yield to maturity, but it assumes the bond is redeemed on the first call date at the call price. For a bond callable at par, price decides the order. Bought at a premium, the loss down to par comes sooner if the bond is called, so yield to call is the lowest: coupon > current yield > yield to maturity > yield to call. Bought at a discount, the gain up to par comes sooner, so yield to call is the highest: coupon < current yield < yield to maturity < yield to call. Yield to worst is the lower of yield to maturity and yield to call. It is the cautious figure to check for any callable bond.

A conversion feature usually runs the other way. It lets the holder exchange the bond for a fixed number of common shares — the conversion ratio is par divided by the conversion price, so a $1,000 bond convertible at $40 becomes 25 shares. The holder converts when the stock has risen far enough that the shares are worth more than the bond. In practice, because the holder gets this upside, convertible bonds usually pay a lower coupon than comparable straight bonds; that is market pricing, not a rule. Some issues give the company, not the holder, the right to decide when conversion occurs.

Parity is the price at which the bond and the shares it converts into are worth the same. When the conversion value is well below the bond’s price, the bond behaves like a bond; when the stock rises so that conversion value nears or passes the bond’s price, the bond tracks the stock. Keep the two features straight by asking who can act: the call is the issuer’s choice and is used when rates fall; the conversion is usually the holder’s choice and is used when the stock rises.

Exam terms

Call price

The amount the issuer pays to redeem a bond early; par or par plus a premium.

Call protection

The initial period during which the issuer may not call the bond.

Call risk

The risk that a bond is redeemed when rates have fallen, forcing reinvestment at lower rates.

Yield to call

Yield assuming the bond is redeemed at the call price on the first call date.

Yield to worst

The lower of yield to maturity and yield to call.

Conversion ratio

Shares received per bond: par divided by the conversion price.

Conversion value

Conversion ratio multiplied by the current market price of the common stock.

Parity

The point at which the bond’s price equals its conversion value.

Worked example

Ulises holds a Vantage Software convertible bond: $1,000 par, 4% coupon, convertible at $40 per share, also callable at 105. The bond trades at $1,150 and the common at $50.

1. Conversion ratio: $1,000 ÷ $40 = 25 shares per bond.
2. Conversion value: 25 × $50 = $1,250. The bond at $1,150 is trading below its conversion value.
3. Converting turns a $1,150 bond into $1,250 of stock; in practice the bond’s price would be pulled up toward $1,250 as buyers spot the gap.
4. If Vantage calls the bond at 105, Ulises receives $1,050 in cash — or converts first and keeps $1,250 of stock. Everyone converts, which is how an issuer uses a call to retire convertible debt without paying cash.

Check yourself

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Related practice

• Call feature: who benefits and whenPractice this