A convertible bond can be converted into a fixed number of shares of the company

Question

A convertible bond can be converted into a fixed number of shares of the company's common stock at the convenience of the bondholder. Assume that Anderson Inc. is a AAA rated company. Further, assume that for AAA rated companies to issue 15 year non-convertible (i.e. straight) corporate debt at par, they must offer a coupon rate of 4.5%. However, Anderson Inc. wants to issue convertible debt. If Anderson Inc. offers a 15 year convertible debt at par, then a. One would expect that the required coupon rate would be greater than, exactly equal to, or less than 4.5% and why? b. If Anderson Inc. issues convertible debt with a coupon rate of 4.5%, will the debt issue sell at par, below par, or above par? Why?

Explanation / Answer

a) The required coupon rate would be lower than 4.5%. This is because a convertible debt would give an option to the bondholder to convert that bond into stock which gives additonal value to the bondholder.

b) If the convertible bond gives 4.5% coupon, then it would sell at a premium or above par because a convertible bond having this additional value of option to convert to equity will be giving same coupon as to non-convertible bond, making it more lucrative.

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