Convertible bond valuation involves a comparatively complex product. It is a bond that the holder can exchange for stock in the issuing corporation. This means that convertible bond valuation must take into account three main factors: the inherent value of the bond, the current value of the stock, and the stated conditions for the conversion. This complexity means there are several models for valuation.
The heart of a convertible bond is a standard corporate bond: a product that a corporation sells for a flat fee in order to raise funding, with a promise to repay the flat fee at a fixed future date along with an interest payment. In some cases additional interest payments are made at regular intervals during the lifespan of the bond. The interest rate for these payments is also known as the coupon rate.
What makes the bond different is that the holder can convert the bond into stock at any time before it is due to be paid back, a point known as the redemption date. Most commonly, the exchange for stock will be at a fixed rate, but sometimes it will be at the prevailing market rate. Convertible bond valuation thus first involves valuing the bond itself. This takes into account the price an investor will pay for the bond, either the face value if buying from the issuing corporation, or the price at which an existing holder wants to sell on the bond. It also takes into account the coupon rate on the bond, and an assessment of the likelihood that the corporation will make the promised coupon payments and face value repayment: in effect, this is an assessment of how likely the company is to go out of business in the near future.
The valuation then has to take into account the additional value of the stock conversion feature. If the bond allows for conversion at the current market value, this is straightforward. If the bond lays down a fixed rate, the valuation must be adjusted to take into account not only the relationship between the fixed rate and the current market price of the stock, but also the predicted movement of the stock price during the rest of the bond's lifespan. The more likely it is the bond holder will be able to exchange the stock at a comparatively favorable rate, the more attractive the bond and thus the higher its valuation.
There are a wide range of models used for convertible bond valuation, varying mainly in the emphasis given to the particular factors. Many models also take into account the current and predicted dividend rate on the corporation stock, as this will be relevant if the bond holder exercises the conversion and then holds on to the stock. Most models will also take into account the current rates available on investments that are considered statistically risk-free, such as government securities. This is because the better the rates available for such investments, the less attractive any risky investment becomes by comparison.
