Convertible debt is a type of loan that can be converted back to stock after some specified future date. When making an investment in convertible debt, both the issuer and investor are clear that there is a possibility of debt being converted into stock in the future. International Account Standard 32 deals with accounting for convertible debt.
A convertible debt instrument is an alternative financing solution, normally used by companies to finance their operation or working capital. The peculiar thing about this arrangement is that both parties can be on the same page regarding an eventual conversion of convertible debt into common stock of the company. In other words, both the issuer and the holder can convert the debt into equity at a future date. However, the former (i.e. the forced conversion) is rare, while the latter (conversion by the holder) is more common.
Sometimes, it is not easy for the company to issue convertible debt because the shareholder may oppose this management decision. This is due to the fact that upon conversion of the debt to equity, the shareholders’ stock values will decline because of the share dilution. Therefore management needs to pursue by performing a cost-benefit analysis as to why the issuance of convertible debt is beneficial to the company and its shareholders at the same time.
An example of a convertible debt
Normally, the company issues the bond at par, but sometimes it can offer a discount to investors in convertible debts as an incentive. For example, Mr. A purchased a convertible bond on January 01, 2020, for $500,000 at $500 each, whereas the par value of the bond is $550. Why has the company offered a discount on the issuance of the bond? It is because investors will be likely to convert their debts into equities.
Why offering a discount?
Debt is senior to equity in terms of payback at times of liquidation. So if an investor is willing to forgo his debt right for equity, then obviously the company has to offer some incentive in order to keep its investment.
Moving forward in the above-mentioned example, if the maturity of the bond is December 31, 2024, this means that after 5 years, the investor can convert and the company can reduce its debts leverage and issue its stocks in place.
Why is issuing a convertible bond good for the company?
A company at times is in need of financing, but they don’t want to increase their debt leverage, therefore they offer a discount to investors for investing in their convertible debt instruments. Once the investment has been made, the company can save itself from a debt burden.
Why is purchasing a convertible bond good for investors?
Often times it is worthwhile to invest in a company’s stock but for some reason, the investor does not want to invest in equity immediately. Therefore a better way is to go for convertible debt and then convert it into equity at a future date. This way, the investor will be in the position of a shareholder. In addition, as discussed above, the investor can be offered a discount as an incentive for investing in convertible debt.
How to account for the convertible debt:
As both the company and investors have the same understanding that after a defined period of time they can convert the debt into common stocks, therefore as per IAS-32, when accounting for the convertible debt, the company has to recognize the issuance of convertible debts as a compound instrument.
Every year the interests accrued on the debt portion of the convertible debt shall be recognized in the profit and loss statement, and at the maturity of that instrument, all the loan shall be converted into equity at par and will be recognized in the capital of the company.
How to price a convertible debt:
A convertible debt is a hybrid security, part debt and part equity. Its valuation is derived from both the level of interest rates and the price of the underlying equity. Several convertible bond pricing approaches are available to value these complex hybrid securities such as Binomial Tree, Partial Differential Equation and Monte Carlo simulation. One of the earliest approaches was the Binomial Tree model originally developed by Goldman Sachs and this model allows for an efficient implementation with high accuracy. The Binomial Tree model is flexible enough to support the implementation of bespoke exotic features such as redemption and conversion by the issuer, lockout periods, conversion and retraction by the share owner.
The Binomial Tree approach for valuing a convertible debt can be implemented in Excel or Python.