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Let's say a Company A has a public offering of $50 million in 7.0% Secured Convertible Notes that matures in 2021 to prospective investors with a conversion price of $2.00. For this example, let's say an institutional buyer comes along and takes the offer. Company A will pay 7.0% interest of the face value until maturity or conversion.

Now my question is how does this conversion work? Specifically on the strike or conversion price. Let's say when it comes to convert the debt to common stock, what happens if Company A stock is trading below $2.00? If it is above than the share price will be diluted and lose some value in the short term. What are the potential scenarios that can occur if the stock is trading below the conversion price?

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Let's assume that the bonds have a par value of $1,000. If conversion happens, then one bond would be converted into 500 shares. The price in the market is unimportant.

Regardless of the share price in the market, the income per share would be increased by the absence of $70 in interest expense. It would be decreased by the lost tax deduction. It would be further diluted by the increase in 500 shares. Likewise, the debt would be extinguished and the equity section increased. Whether it increased or decreased on a per share basis would depend upon the average amount paid in per share in the currently existing structure, adjusted for changes in retained earnings since the initial offering and for any treasury shares.

There would be a loss in value, generally, if it is trading far from $2.00 because it would be valued based on the market price. Had the bond not converted, it would trade in the market as a pure bond if the stock price is far below the strike price and as an ordinary pure bond plus a premium if near enough to the strike price in a manner that depends upon the time remaining under the conversion privilege.

I cannot think of a general case where someone would want to convert below strike and indeed, barring a very strange tax, inheritance or legal situation (such as a weird divorce), I cannot think of a case where it would make sense. It often does not make sense to convert far from maturity either as the option premium only vanishes well above $2. The primary case for conversion would be where the after-tax dividend is greater than the after-tax interest payment.

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  • Thank you for the answer. In the 3rd paragraph, when you say loss in value if trading far from 2.00. Do you mean the value of the bond and if the pps is trading far below $2? – VeryIgnorantPerson Mar 24 '17 at 3:23
  • And also, for the example, this bond matures in 2021, but conversion can take place anytime prior regardless of the current extrinsic value in the current time or is there usually a time frame specified within the prospectus? – VeryIgnorantPerson Mar 24 '17 at 3:25
  • Let's assume the stock trades for 1. You decide to convert a $1000 bond. You now have 500 shares that you could resell for $500. Why would you do that when the bond could never trade below $500, even in high-interest rates because the stock would act as a floor, and may even trade at a substantial premium as a bond if rates have fallen enough. – Dave Harris Mar 24 '17 at 3:33
  • The conversion depends upon the trust indenture agreement, which should be described in the prospectus, and it does not depend on the maturity, except that the entire contract expires at maturity. – Dave Harris Mar 24 '17 at 3:35

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