A bond that can become stock
A convertible note pays interest and returns principal at maturity like a bond, but it also carries the right to convert into the company's shares under set conditions. The company borrows at a lower rate than with an ordinary bond, and investors get the chance to profit by converting if the share price rises.
For existing shareholders, conversion means more shares and a smaller stake. This guide calculates, with hypothetical scenarios, how the conversion price, the number of conversion shares, and reset clauses that lower the conversion price change the size of dilution. It also covers how diluted earnings per share is calculated and which terms to check in disclosures.
Numbers in the term sheet
Investor.gov describes convertible securities as bonds or preferred shares that can be converted into common stock and notes that, in most cases, the holder decides whether and when to convert. The first figures to find are principal, coupon, maturity, conversion price, and conversion period. Principal divided by the conversion price gives the number of shares that could be issued.
Adjustment clauses come on top. Common ones include reset (or refixing) clauses that lower the conversion price when the stock falls, adjustments for stock splits and dividends, call options that let the company repay early, and put options that let investors demand early repayment. These clauses largely determine actual dilution.
Hypothetical dilution scenarios
The table assumes a company with 9 million shares outstanding issues a note with principal of 10 billion won and a conversion price of 10,000 won. A reset clause allows the conversion price to fall to 70% of the initial price.
| Scenario | Conversion price | Shares issued on conversion | Total shares after | Existing holders' stake |
|---|---|---|---|---|
| Converted on original terms | 10,000 won | 1,000,000 | 10,000,000 | 90.0% |
| Reset lowers the price | 8,000 won | 1,250,000 | 10,250,000 | 87.8% |
| Reset to the floor | 7,000 won | ≈ 1,428,571 | ≈ 10,428,571 | 86.3% |
| Not converted, repaid at maturity | — | 0 | 9,000,000 | 100% (10 billion won repaid in cash) |
The lower the conversion price, the more shares the same principal buys and the larger the dilution. Without conversion there is no dilution, but the company must repay principal in cash.
The effect of reset clauses
A reset clause protects investors by lowering the conversion price when the stock falls. For existing shareholders, it means dilution grows just as the price has already dropped, a double disadvantage. In the table, a reset from 10,000 to 7,000 won increases conversion shares by about 43%.
So check how often resets occur, for example every three months, how the reference price is set, and the floor on the conversion price. With no floor or a very low one, dilution during a falling market becomes hard to estimate in advance.
Calculating diluted EPS
IAS 33 requires companies with securities that could become shares, such as convertible notes, to disclose diluted earnings per share assuming full conversion. The denominator adds the conversion shares, and the numerator adds back the after-tax interest that would no longer be paid.
If the company in the table earned net income of 9 billion won, basic EPS is 9 billion ÷ 9 million = 1,000 won. With a 3% coupon and a 22% tax rate, after-tax interest is about 234 million won, so diluted EPS is (9 billion + 234 million) ÷ 10 million ≈ 923 won. The gap shows the burden that possible conversion places on per-share figures.
Accounting and disclosure
IAS 32 treats instruments like convertible notes, which combine debt and equity features, as compound instruments and in principle splits them into a liability component and an equity component. If reset terms prevent the conversion option from qualifying as equity, it may instead be classified as a derivative liability, with changes in its value running through profit or loss as the share price moves.
In that case, a rising share price creates a valuation loss and a falling price a gain, unrelated to operations, which can make net income swing. If profits change suddenly, look in the notes for fair-value changes on convertible notes.
- Find principal, coupon, maturity, conversion price, and conversion period; divide principal by the conversion price to get conversion shares.
- Check the reset frequency, how the reference price is set, and the conversion price floor.
- Review the conditions and timing of call and put options.
- Compare conversion shares with shares outstanding to estimate maximum dilution.
- In the notes, check the accounting classification of the conversion option, its valuation gains or losses, and diluted EPS.
Share price and the conversion decision
If the share price is well above the conversion price, investors are better off converting; if below, they are better off holding the note and taking repayment. When the price hovers near the conversion price, the prospect of conversion shares reaching the market can weigh on it.
If the price falls far enough that conversion looks unlikely, the company must repay principal in cash at maturity or when a put is exercised. Then repayment funding matters more than dilution. When reviewing a convertible, work out both outcomes.
A company with several convertible series outstanding can face both at once: some series deep out of the money heading for cash repayment, others near their conversion price. Adding them up series by series gives a clearer picture than any single headline figure.
Limits of the analysis
The amounts, share counts, and tax rate here are hypothetical. Real convertible notes vary widely in terms, and many companies have several series outstanding at once.
When looking at a real company, check the latest issuance disclosures and notes on DART or EDGAR with their dates. This guide does not recommend buying or selling any security.