Convertible Bonds – Practical Valuation and Accounting Insights

Convertible Bonds – Practical Valuation and Accounting Insights

Convertible bonds (CBs) combine features of debt and equity/derivative instruments, so their valuation and disclosures depend heavily on instrument terms and accounting classification.

Auditors and issuers often engage Valtech for advisory support in addressing issues related to significant Day-1 gains or losses arising from unobservable inputs in valuation models. These challenges typically occur when internal or external valuation models produce large Day-1 differences, especially for issuers whose stock prices have been highly volatile.

The Valuation Landscape: Model Discipline Meets Market Complexity

Valuation specialists commonly use the binomial model to price convertible bonds. They typically follow established in-house procedures, such as standardized approaches for determining key inputs — for example, using historical volatility and estimating the effective interest rate (EIR) based on the risk-free rate plus a credit spread. However, model assumptions can differ across firms, and these embedded assumptions may lead to price discrepancies in real-world markets.

For instance, the Black-Scholes model does not explicitly account for stock borrowing costs because it assumes investors can borrow and lend unlimited amounts at a constant risk-free rate. This means it does not distinguish between lending and borrowing costs on the underlying stock — a practical limitation when valuing real-world options.

Another common assumption is that of constant volatility. While this is generally acceptable, when historical volatility is high, using it directly can overestimate the conversion option value. In practice, stock prices and volatility often move inversely, so real-world valuation may differ from the theoretical model.

Further Sharing: Valtech Understands the Accounting Implications

• Fixed-for-fixed conversion → Typically classified as a liability (host) and an equity component. The equity component is not subsequently remeasured.
• Non-fixed-for-fixed / settlement options / resets / cash alternatives → The conversion leg is treated as a derivative liability measured at FVTPL.

How Valtech Build the Right Valuation

• Host debt (if separated):
  Discounted cash flow using the issuer’s or borrower’s credit spread. Disclose the effective interest rate (EIR), carrying amount, and fair value if required.
• Conversion or derivative component:
  • Vanilla (fixed terms): Use option-pricing models (e.g., binomial or Black-Scholes with credit/jump adjustments).
  • Path-dependent / ratchets / resets / contingent conversions: Use Monte Carlo simulation incorporating state variables such as stock price, credit, FX, dividends, reset triggers, and change-of-control events.
• Core inputs to disclose (especially for Level 3 valuations):
  • Risk-free curve and credit spread (issuer’s own credit for liabilities; counterparty credit for holders if applicable).
  • Equity volatility, dividend yield, and stock-borrow constraints.
  • Conversion price mechanics (fixed vs. variable; floors/caps; reset rules).
  • Other assumptions (e.g., early call/put exercise behavior).

Other Common Valuation Challenges Valtech Can Help

1. Private or unlisted equity / illiquid credit

• Volatility and credit spreads are often unobservable → Level 3 measurement with a wide input range.
• Use peer-group volatilities, implied volatilities from comparable entities, or adjusted historical volatilities.
• Triangulate credit assumptions with rating benchmarks or recent private debt pricing.
• Provide robust sensitivity analyses and clear methodological disclosure.

2. Modifications, exchanges, or forced conversions

• Assess whether the change constitutes extinguishment or modification — this often involves judgment.
• Track changes in features between the original and revised terms.
• Disclose the accounting assessment and its financial impact.

Deliverables to Support Auditor Review

To facilitate auditor review, Valtech’s deliverables typically include:

• Instrument terms table — maturity, coupon, conversion price/range, resets, puts/calls, and other key features reflected in the valuation model.
• Valuation methodology — detailed explanation of models used, key inputs and assumptions, and identification of Level 2 and Level 3 inputs.
• Sensitivity analyses — for example:
  • Volatility ±5–10 pts
  • Credit spread ±100–200 bps
  • Equity price ±10–20%
  • FX rate ±10% (if relevant)