Question

Typically, it will be optimal for bondholders to wait on exercising their option to convert until just prior to maturity. Why? (3)

In what kind of situation is it optimal to exercise the conversion option earlier than that? (3)

Answer 1

A convertible bond is a fixed-income corporate debt security that yields interest payments, but can be converted into a predetermined number of common stock or equity shares. The conversion from the bond to stock can be done at certain times during the bond's life and is usually at the discretion of the bondholder.

A convertible bond offers investors a type of hybrid security, which has features of a bond such as interest payments while also providing the opportunity of owning the stock. Generally bond will be converted into shares just before maturity. Bondholders will not exercise the conversion option before maturity as any appreciation in capital gains on shares will be directly or indirectly will be absorbed in the price of the bond if its value is higher than the straight value of bond.

Hence capital appreciation cannot be the reason for early exercise of conversion option. Only difference between owing the shares or call to buy the shares is the dividend component. Dividend will only be received by the shareholder who owns the shares and not a holder of call. Hence if the investor feels the return on dividend after converting into shares will be higher than the effective return on the bond upto maturity, investor may convert the bonds into shares before maturity.