How is convertible bond valuation different than traditional bond valuation?

Convertible bonds have features of equity securities since they can be conditionally converted into shares. This makes them more sensitive to company-specific news and less sensitive to systematic economic conditions, at least when compared with traditional bonds. The valuation of a convertible bond must therefore carry features of bond valuation and equity valuation.

The equity conversion option acts like a call option for the underlying company's stock. Like call options, value changes based on the variance in underlying stock price, conversion ratio, interest rates and the maturity of the option instrument.

Valuation is the term used to describe the process of determining a financial asset's fair value. Almost every basic valuation model focuses on finding the present value of an asset's expected future cash flows.

Estimating cash flow for bonds can be difficult. Traditional bonds, where neither issuer nor investor can alter the contractual payments or maturity dates, can be determined relatively easily as long as concerns about default are left aside for a moment.

The problem is that most bonds have some form of embedded options or other conditional alterations to future cash flows. Bonds can be putable or callable, carry accelerated redemption options, might have a floating rate or might be convertible.

Traditional bond valuation involves three steps: an estimate of expected future cash flows; a way to determine a reasonable discount rate for future cash flows, although multiple discount rates might be used; and a way to apply the discount rate(s) to the expected future cash flows to arrive at a present value.

Future cash flows should be equal to the yet-unpaid coupons left before maturity plus the face value of the bond at maturity. Discount rates cannot be set as neatly; they need to be adjusted as current yields adjust. The relationship between bond value and discount rates is the same as the relationship between bond prices and yields: the lower the discount rate, the higher the value of the bond and vice versa.

Convertible bonds have an embedded ability to be converted into stocks. This is sometimes referred to as the "equity participation feature." There are multiple methods for valuing convertible bonds. Some are relatively simple, but others are more detailed and try to answer difficult questions. A difficult question might be how to value the conversion premium per share or convertible bonds that also have call and put options. The investor might want to anticipate the impact of interest rates on stock prices and how that could change convertible values.

One of the most common and simplest valuation methods for convertible bonds can be expressed as: Value of convertible bond = independent value of straight bond + independent value of conversion option.

Convertible bonds are somewhat paradoxically less risk-sensitive than traditional bonds. This is because increased risk decreases the value of debt security features and increases the value of the conversion option.