Unsecured Bond Valuation
Unsecured bonds are referred to as debentures and are not backed by any form of collateral other than the companies good name and past credit worthiness. Two levels of debentures exist: debentures and subordinated debentures. Investors purchasing debentures face a greater amount of risk than those investors purchasing secured bonds and therefor will demand a greater interest rate. Subordinated debentures will require an even greater risk level and interest rate because subordinated debenture claims come after debenture claims in the event of a bankruptcy.
Generally mostly well known companies with good credit standings will choose to offer debentures as their good name alone will attract investors. However, companies that are not well known or lacking high credit ratings will also offer debentures, but they will pay a higher price compared to a company with a good credit standing or public image.
Another way to attract investors to unsecured debt or debentures is to offer a conversion feature allowing the debentures to be converted to shares of common stock. A convertible bond will have a conversion price which is the price at which the bond can be converted to stock. Using the conversion price, a conversion ration can be obtained telling investors how many shares a bond can be exchange for. An example of how to computed the conversion price of is found below.
Conversion Ratio = Bond's Par Value / Conversion price = shares per bond
For an investor to make an informed investment decision about exactly when to convert a bond to common stock, another set of analysis must be performed. As an investor, you want to know at what stock price should you convert your bonds into stock. Investors are interested in conversion when the price of stock multiplied by the conversion ratio is at least equal to or greater than the bond's value. When the value of the bond and the value of the stock received at conversion are equal, it is said that bond and stock are trading at parity.
To determine the parity price of stock you use the following formula:
Parity Price of Stock = Market Price of Bond / Conversion ratio
The parity price of a bond can be found by using the following formula:
Parity Price of Bond = Conversion Ratio x Share Price of Stock
The opportunity for conversion exists when bonds are selling for less than their parity price. This is a potential profit center because bonds do not trade in the same markets as stocks do, and bond prices are affected by interest rate movements whereas stock prices are affected by a companies earnings. When this opportunity exists an arbitrage opportunity presents itself created a possible profitable opportunity.
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Other Resources
The Bond Book: Everything Investors Need to Know About Treasuries, Municipals, GNMAs, Corporates, Zeros, Bond Funds, Money Market Funds, and More
Corporate Bonds and Structured Financial Products
