Convertible Bonds: How Much Equity, How Much Debt?

Financial analysts need accurate estimates of debt, equity, leverage, and EPS. The method proposed here, based on the probability of conversion, yields new estimates of the debt and equity in a convertible bond issue. When this method is used, the value of the equity component in a hypothetical issue is found to be substantial—larger than the value of the options and clearly larger than zero, which is assigned under current accounting rules. The estimate of the debt component is smaller than recorded under current accounting rules. Thus, the leverage of convertible bond issuers is substantially lower when this method is used. Convertible bonds, which can be converted into shares of the issuer's stock, have some probability of remaining bonds and some probability of being converted into stock. Although, on the face of it, these bonds seem to be part debt and part equity, under current accounting rules, convertibles are counted entirely as debt until converted or paid off.We discuss a new approach for determining the debt and equity portions of a convertible bond that is consistent with modern finance theory and grounded in economic reality. In this approach, we view convertible bonds as part equity, part debt, with the proportions depending on the probability of conversion, and show how that treatment affects the analyst's picture of the company's financial structure.Using a typical convertible bond structure, we illustrate our method of estimating the embedded equity and contrast the results with those found by following current accounting guidance and those based on the straight bond/option decomposition. Our measure of the equity component of the convertible bond is substantial—larger than the value of the embedded stock options and also larger than zero, which is the amount of equity assigned to a convertible issue under current accounting rules. The debt component, measured by our method, is much smaller than the total value of the convertible and also much smaller than the value of the straight bond (the value of the convertible bond minus the options). As a consequence, the leverage calculated with our method is substantially lower than that based on the two other methods.Over time, of course, the probability of conversion changes, and so do the debt, equity, and leverage of the issuer derived from our approach.The probability of conversion can also be applied to estimate dilution. According to our method, the shares attached to the convertible issue during the bond's life are many fewer than the total potential shares, the measure used under current accounting rules to calculate EPS. Consequently, EPS is higher under our method until the bond is converted.Financial analysts need estimates of leverage and EPS that reflect economic reality. As we show, the difference between the numbers derived from our method and the numbers resulting from the current accounting rules is too large to ignore. The current accounting rules create a distorted, highly negative view of the capital structure and EPS of convertible bond issuers at the time of issue. Unless the accounting profession embarks on a dramatic rethinking of equity embedded in convertible issues, financial analysts will need to do their own calculations; we provide a method for doing so.