20th letter to friends of Brunei [Convertible Bonds (Part 1)]

On 26 May 2007, CapitaLand (a listed government-linked firm which is also the biggest property company, by assets, in Singapore) raised $1 billion through a convertible bond sale. It was then the biggest convertible bond sale in Singapore.

The 15 year bond (face value $1000) pays 2.95% allows investor to convert into CapitaLand shares at a conversion price of around $10.

Let's use this example to study the convertible bond valuation.

1. Conversion Ratio

Conversion ratio is the number of shares you are entitled to receive on conversion. The formula is as follows:

Conversion Ratio = Face Value / Conversion Price

In CapitaLand's example, the conversion ratio = $1000 / $10 = 10 shares

2. Conversion Value

Conversion value is the market value of the shares obtained when the bond is converted. The formula is as follows:

Conversion value = Conversion ratio x Current share price. (let's use current share price of $4.48)

In CapitaLand's example, the conversion value = 10 x $4.48 = $44.80

3. Conversion Premium (or Discount)

This is the difference between the market price of the bond and its conversion value.

Conversion premium ($) = Market price of the bond - Conversion value

InCapitaLand's example, the conversion premium = $1000 - $44.80 = $955.20

(note: As the market price of bond fluctuates, the conversion premium also changes over time)

4. Bond Price Parity (BPP)

BPP answers the question : "What should the price of the convertible bond be such that there is no difference in price between buying the shares directly and buying the convertible and then converting?"

This value is actually the conversion value. Assuming CapitaLand's share is now $5,

the BPP = 10 shares x $5 = $50.

This is the price which investor can either buy the shares direct or convert the bond.