Introduction

A convertible bond is a hybrid security that has the behavior of (subordinated) debt and stock, as desired by the holder of convertible. As such, it is similar to a reverse convertible, only here, the holder, and not the issuer, has the choice between payoff as a bond or payoff in shares.

What is it?

When one buys a convertible, one buys a bond and a call warrant. This means one profits if the shares of the company rally, but is not affected as strongly by the downside, namely a drop in share price. The only point at which this becomes an issue is if the issuers goes bankrupt: in this case, both bond and shares are worthless.

Because the buyer of the convertible bond also receives a warrant, the interest rate on the bond is lower than for a normal bond of this company. As such, it represent an option for companies to raise capital at relatively low cost. The disadvantage is that if the company flourishes, and the share prices rises, the warrant will probably be exercised: at this point, there will be dilution, as the number of shares increases, decreasing the earnings per share.

The price at which the holder of the bond can convert is not necessarily the share price at the moment of issuing. In general, this price, which is in essence the strike of the warrant, is higher than the share price at the moment of issuing. This means that the share would need to rally significantly for the owner to make money.

Convertibles and Exchangeables

There is a technical difference between a convertible bond and a so-called exchangeable. In the former case, the company whose shares or bond is the underlying will pay you. In the latter case, it is a third party, commonly a bank. In practice, convertibles and exchangeables are nearly the same, with one small difference that we will discuss when we discuss risk. Always check whether the product you want to trade is a convertible or an exchangeable.

Risks

Bankruptcy of the issuer

The main risk for the holder of a convertible bond is the risk that the issuer goes bankrupt. In this case, the investment is lost. Otherwise, the owner makes at least the coupon, which ordinarily is at least as much as the risk-free rate. There are, however, other risks, that are mostly fluctuations in the mark-to-market price of the convertible bond.

This is a particularly vicious scenario if the bond is subordinated. In this case, one likely loses the whole investment. It is quite common for convertible bonds to be subordinated. Put differently, there are companies whose subordinated debt is so risky that the only way to get it financed at an acceptable rate is to make it a convertible bond. For instance, a bond that might pay 15 percent interest gets chopped up in a bond that pays only 5 percent, and a warrant that should (hopefully) be worth roughly as much as the difference. This can be verified by checking a similar option, which should be roughly worth the same.

Drop in the share price

If the share price drops, the warrant drops in value. In the worst case scenario, the warrant becomes almost worthless, leaving the owner with a risky bond with an unattractive interest rate. This is particularly nasty if it happens early in the life time of the convertible security; near the end, the credit risk has also gone. down. It is noted than an increase in dividend may have the same impact, as paid dividends lower the share price.

Drop in the volatility of the share

This decreases the value of the warrant. Normally, this is not very killing, as lower volatility often also means that things are going better with the underlying, reducing the credit risk and often leading to a higher share price.

Increase in interest rates

This is in essence no different from the normal interest rate exposure of a bond. If the interest rates go up, bonds at a lower interest rate become less valuable.

The issuer becomes less credit-worthy

The debt of issuers with a low credit-worthiness is worth less than the debt of issuers that are credit worthy. As such, a drop in the creditworthiness of the issuer leads to an immediate decrease in the value of the bond. Note that normally, this is quite bad for the share price as well.

Investing in convertibles

As seen from the risks above, the holder of a convertible bond broadly faces the same risks as the holder of stock, although the exposure to the share price is in general substantially lower. Still, one risks the total investment by buying a convertible bond. As such, it is a pretty bullish position.

On the other hand, if the issuer does not go bankrupt, and one can hold the position until expiry, one generally at least does not lose on it. As such, it is not as risky as shares. Basically, a convertible is a sensible investment for someone who thinks a company will survive, and may actually thrive, increasing the value of the shares, but is a lot less certain of the second statement than of the first].

One practical aspect is that convertibles are a lot less liquid than stocks and bonds. As such, it is more difficult to trade them, and there is a substantial liquidity risk. Furthermore, it is not uncommon to add creative financial engineering to convertible bonds. This makes valuation and replication more difficult, which generally benefits the issuer more than the investor.

Conclusion

Convertible bonds are bonds that can be paid back in shares or in cash. As such, they are hybrid securities with a risk profile that is between ordinary bonds and stock. They are issued to allow a company to finance its debts at an acceptable rate; the fact that if the share price rallies, the stock is diluted is seen as acceptable.

Disclaimer: This is not investment advice. Don't take investment advice from random people on the Internet.

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