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.