Convertible Bonds: Debt That Can Become Equity

A convertible bond is a loan the holder may turn into ordinary shares instead of taking the money back. Because it carries both an obligation to repay cash and an option to become a shareholder, the accounts split it: the liability is measured first, at what a plain loan without the option would be worth, and the remainder of what was raised is equity. Reported interest then exceeds the coupon actually paid.

Underneath the answer sits the test that separates a liability from equity. The test asks one question only: can the business avoid handing over cash? A convertible bondA bond whose holder may exchange it for a stated number of ordinary shares instead of being repaid in cash. Also called a convertible note or a convertible debenture depending on how it is issued. answers that question twice, and it gives a different answer each time. On one leg the business must repay cash. On the other leg the business settles by handing over its own shares, and handing over shares is not a payment of cash at all. Neither answer is wrong. So the accounts stop treating the instrument as one thing.

Anjani Stationers Private Limited, an invented stationery business, has issued no convertible instrument of any kind. The convertible worked below is therefore a supposition placed beside its published accounts, never inside them. The published finance cost of Rs 3,50,000 for year two contains nothing from that teaching case, and neither does the published share capital of Rs 40,00,000 on 4,00,000 ordinary shares.

What is a convertible bond, and what does the holder actually hold?

A concrete case comes before the definition. A household pays Rs 5,00,000 as a deposit on a flat still being built. The agreement says two things at once: if the building is finished on time the household takes the flat, and if it is not, the builder returns the Rs 5,00,000 with interest. The household is not holding one thing. The household is holding a loan and a right, and it will decide later which of the two it wants. The household takes the flat if the flat turns out to be worth more than the money back, and takes the money back otherwise. Nobody had to decide on day one.

A convertible bond is that arrangement written as a security. The bond has a face valueThe amount printed on a bond, being the sum the issuer must repay at maturity and the base on which the coupon percentage is applied. Also called the nominal or principal amount., the sum repayable at the end. The bond pays a couponThe cash interest an instrument pays, stated as a percentage of face value and fixed in the contract. The coupon is what actually leaves the bank account, whatever the accounts later report as a finance cost., which is cash interest at a stated percentage of face value. And it carries a conversion ratioThe number of ordinary shares the holder receives for each unit of face value on conversion, fixed when the instrument is issued. The ratio fixes the exchange rate between the bond and the shares in advance., which fixes in advance how many ordinary shares the holder gets if the right to convert is used. Face value, coupon and conversion ratio are written on day one, and none of the three changes afterwards.

The holder of a convertible bond holds two separable things at once, a claim to be repaid in cash and a right to become a shareholder instead, and the right is a choice the holder makes later rather than a promise the business made. Watch which side each of those two sits on. The repayment claim points at the business: the business must find the cash unless the holder chooses otherwise. The conversion right points at the holder: nobody can force the holder to use it, and nobody can stop the holder using it if the terms are met. The asymmetry between the two legs is the entire instrument. One leg is an obligation the business cannot escape, and the other leg is a decision the business does not get to make.

Why can the borrower pay a coupon below what a plain loan would need?

Because the borrower is not paying only in cash. A shopkeeper lets a regular customer take goods at a lower price on the understanding that the customer will use only that shop for the year. Something else moved across the counter in the other direction, so the price came down and nothing was given away. The lower price is the visible half of a two sided bargain, and reading only that half makes the shopkeeper look generous when in fact a trade took place.

A convertible bond works the same way. Suppose Anjani Stationers, entirely hypothetically, raised Rs 20,00,000 on a five year bond paying a 5 per cent coupon. The coupon is Rs 1,00,000 of cash a year. A plain loan of the same amount and the same term, from the same lender with the same security and no conversion right attached, would have needed 10 per cent. At 10 per cent the cash is Rs 2,00,000 a year. The 10 per cent is the rate Anjani Stationers already pays on its existing term loan, the natural rate for a plain loan from the same lender. A different plain loan rate would move every figure below, and the panel further down shows by how much. The visible half of the bargain is that the business pays Rs 1,00,000 a year less in cash for five years, and keeps Rs 5,00,000 of cash as a result.

The lower coupon on a convertible bond is not a concession the lender made, it is the price the lender charged for the conversion right, and a reader who counts only the cash saving has recorded one side of an exchange and dropped the other. The investor accepted Rs 1,00,000 a year less because the investor received something instead: the right to take 40,000 ordinary shares if that turns out to be the better outcome. The business handed over a claim on its own future ownership. Nothing was free. The exchange is why the accounts refuse to record the whole Rs 20,00,000 as a loan, and it is also why the split, when it is computed below, comes out at exactly the value of the coupon concession.

Why do the accounts refuse to treat it as one instrument?

Because the classification test, applied honestly, returns two answers on the same certificate, and there is no honest way to pick one of them. The test runs leg by leg. The repayment leg obliges the business to hand over cash it cannot avoid, so on that leg the answer is a financial liability. The conversion leg is settled by delivering a fixed number of the business's own ordinary shares, and delivering its own shares is not delivering cash, so on that leg the answer is equity.

An instrument carrying a contractual obligation to deliver cash on one leg and settlement in the issuing business's own shares on the other is not classified by choosing between the two answers, it is separated into two components at the moment it is first recognised and each component is classified on its own. What has and has not happened there is worth being exact about. The test was not weakened, bent or averaged. The test was applied twice, and it gave a clean answer each time. The unit being tested changed: not the certificate, but each of the two things inside it. The name on the front of the document decided nothing, exactly as a name decides nothing anywhere else in classification.

How is the split actually computed?

In one order, and the order is the whole of the method. The liability is measured first, at what the same payments would be worth as a plain loan carrying no conversion right. Whatever the investor paid above that figure is the equity componentThe part of what was raised on a compound instrument that is credited to equity rather than to liabilities, computed as the amount received less the measured liability part., and it is credited to equity. The equity part is never measured directly and never revalued afterwards. The equity part is a residual, in exactly the sense equity is always a residual: what is left after the measurable claim has been taken out.

Before the arithmetic, look at what Anjani Stationers actually reports. The contrast is the point. Its published finance cost of Rs 3,50,000 for year two is built from three things and only three: Rs 2,64,000 on the seasonal cash credit facility, Rs 41,000 on the term loan and Rs 45,000 on the lease liability. There is no fourth instrument, so there is no fourth component.

Now the hypothetical, worked in full. The business raises Rs 20,00,000 on a five year convertible bond with a 5 per cent coupon, so Rs 1,00,000 of cash leaves each year and Rs 20,00,000 is repayable at the end unless the holder converts. A plain loan on the same terms without the conversion right would have carried 10 per cent. The 10 per cent is what the lender demanded for the repayment leg alone. Discount the cash flows the holder is contractually entitled to, five coupons of Rs 1,00,000 and the Rs 20,00,000 at the end, at that 10 per cent rather than at 5 per cent.

The equity component is computed as the remainder rather than measured on its own, so the two components sum back to the Rs 20,00,000 actually received. The sum is not a coincidence to be checked but the definition of the method. Now look at the first line of that table again, because it is doing something quietly remarkable. The equity component of Rs 3,79,079 is identical to the present value of the Rs 1,00,000 a year coupon saving, discounted at the same 10 per cent. The identity holds at every rate and is not an artefact of these numbers: the equity component is arithmetically the present value of the concession the investor granted on the coupon. The investor charged for the conversion right by cutting the cash coupon, and the split simply prices that cut.

Why does the reported interest exceed the coupon actually paid?

The excess is the part that looks strange, and it follows from a sentence already accepted. The business received Rs 20,00,000 but recorded a liability of only Rs 16,20,921. The business will nonetheless have to repay Rs 20,00,000 if the holder does not convert. So the liability has to travel from Rs 16,20,921 to Rs 20,00,000 across the five years on its own, and that upward travel is called accretionThe gradual increase of a liability's carrying amount towards the sum repayable, recorded as a finance cost each period. Nothing leaves the bank account when a liability accretes..

The mechanism that does the travelling is the effective interest rateThe rate that makes everything a borrowing will pay equal the amount actually received at the start. The rate is applied to the carrying amount each period to produce the reported finance cost., and here it is the 10 per cent plain loan rate. Each year, apply 10 per cent to the opening carrying amount to get the reported finance cost. Take out the Rs 1,00,000 of coupon that actually left the bank. Whatever is left is added to the liability. Do it five times and the liability lands on Rs 20,00,000 exactly.

The business reports Rs 8,79,079 of finance cost across the five years while paying only Rs 5,00,000 in cash. The Rs 3,79,079 difference is not a payment anybody makes. It is the unwinding of the discount: the equity component travelling back through profit or loss as interest. The unwinding is the neatest fact about the instrument. The gap between reported cost and cash paid, added up over the whole term, is Rs 3,79,079, the equity component to the rupee. The match has to be so: the liability began Rs 3,79,079 below its repayment amount and had to arrive at that amount, so exactly Rs 3,79,079 of extra cost had to be recorded on the way. Rs 1,00,000 a year is all that ever left the bank, so the cash flow statement shows Rs 1,00,000 a year and nothing else.

Three readings from the panel carry the point. At the default 10 per cent the split is Rs 16,20,921 and Rs 3,79,079, and year one reports Rs 1,62,092 against a Rs 1,00,000 coupon. Push the plain loan rate to 15 per cent and the liability falls to Rs 13,29,569 while the equity component rises to Rs 6,70,431, with year one reporting Rs 1,99,435. Now drag the slider all the way down to 5 per cent, where the plain loan rate equals the coupon. The liability becomes Rs 20,00,000, the equity component becomes nil, the reported finance cost becomes Rs 1,00,000 in every year and the climb flattens into a straight line. When a plain loan would have needed exactly the coupon the instrument pays, there is no equity component at all. The equity component is therefore nothing more and nothing less than the measured value of the rate concession the investor granted.

What happens on conversion, and what happens if it never converts?

Two endings, and the second one is where careful readers still go wrong. Take conversion first, at the end of the five years. The holder hands back the bond and takes 40,000 ordinary shares of Rs 10 each. The liability, by then accreted to Rs 20,00,000, stops being a liability. The equity component of Rs 3,79,079 has been sitting in equity since day one. Both are now credited to share capital and securities premium: Rs 4,00,000 to share capital, being 40,000 shares at their Rs 10 nominal amount, and Rs 19,79,079 to securities premium, together Rs 23,79,079.

Nothing has been sold, settled or forgiven on conversion. Every rupee involved has simply moved from one part of the balance sheet to another under a term written into the instrument on the day it was issued, so no gain and no loss arises. That is worth defending, because the instinct is to look for a profit. The business extinguished a Rs 20,00,000 liability and handed over shares. If the shares had been sold for cash that day, would the price have been Rs 20,00,000? Possibly not. But the accounts do not run a conversion through a market: the terms fixed the exchange in advance, the holder simply took what was already agreed, and profit or loss records nothing at all.

Now the second ending, and read it slowly because it is the one people get wrong. The holder does not convert. The liability has accreted to Rs 20,00,000, the business pays Rs 20,00,000 in cash, and the liability is gone. The conversion right expires unused and worthless. So what happens to the Rs 3,79,079 sitting in equity?

An option that expires unexercised does not come back as profit. The Rs 3,79,079 was paid for on day one, and the passing of a date does not undo a payment already received, so it stays inside equity, and the most that happens is a transfer from one component of equity to another. Test the logic against something ordinary. A shopkeeper takes Rs 5,000 from a customer for the exclusive right to buy a particular machine within a year. The customer never buys it. The Rs 5,000 was already the shopkeeper's money from the moment it was received, so it does not become income at the end of the year. The shopkeeper sold a right and delivered it, and the customer simply chose not to use what was bought. The same is true here. The investor paid Rs 3,79,079 for the conversion right by accepting a lower coupon, and the business received it. Whether the right is used later changes who ends up holding shares. Using the right or not does not change the fact that the money came in and was recorded correctly on the day it did.

What does a convertible do to earnings per share?

A convertible puts a second figure beside the first one. Basic earnings per share divides profit after tax by the shares actually in issue. Diluted earnings per share asks a different question: what would that figure have been if everything capable of becoming a share already had. A convertible instrument is exactly such a thing, so the diluted calculation assumes the conversion happened at the start of the period.

A business whose bond had already converted would carry more shares and would also have reported no finance cost on the instrument at all. So a convertible instrument changes both halves of the earnings per share fraction. A share option changes only the share count. That second half is the part people miss. The shares go up, and that pushes the figure down. The reported finance cost on the liability part would never have arisen, so the profit goes up too, and that pushes the figure back up. How the two effects are set against each other, and the order in which several dilutive instruments are tested, is a measurement set out separately. The published position stands: Anjani Stationers has 4,00,000 ordinary shares in issue, reported basic earnings per share of Rs 7.50 for year two, and carries no convertible instrument, so the hypothetical bond changes none of those figures.

Who reads a convertible in a set of accounts, and what do they do with it?

Three different people open the same borrowings note in the same week, and none of them is looking for the same thing. Leave the mechanism for a moment.

A lender counts the cash the instrument can demand and on what date, an analyst building a forecast reads the effective rate rather than the coupon, and Vaidehi Rao as finance controller watches the share count that would exist if every convertible converted at once. Work each of them through. The lender's question is a cash question and nothing else: if the holders do not convert, Rs 20,00,000 must be found on a stated date, and that date sits somewhere in the lender's own repayment period or it does not. A convertible is not a soft obligation merely because it might turn into shares. The instrument might not convert, and the lender plans for the version where it does not.

The analyst's use follows directly. Forecasting next year's finance cost on an instrument like this takes the carrying amount and the effective rate, both of which are disclosed in the borrowings note, multiplied together. The coupon on the front of the instrument gives the cash flow forecast and understates the profit and loss charge every single year. And Vaidehi Rao, sitting inside the business, reads it for a third reason entirely. A decision taken on today's 4,00,000 shares looks different once every instrument capable of becoming a share has been added up. So before she puts any proposal about ownership to the board she wants the count of shares that could exist, not the count that does. All three of them are reading the same note for a number the face of the balance sheet does not carry.

Anjani Stationers Private Limited, Chitra Binding Works Private Limited and Vaidehi Rao are invented.
Educational material. Not advice on any investment, tax, budget or market position.