Convertible bond


In finance, a convertible bond or convertible note or convertible debt is a type of bond that the holder can convert into a specified number of shares of common stock in the issuing company or cash of equal value. It is a hybrid security with debt- and equity-like features. It originated in the mid-19th century, and was used by early speculators such as Jacob Little and Daniel Drew to counter market cornering.
Convertible bonds are most often issued by companies with a low credit rating and high growth potential. Convertible bonds are also considered debt security because the companies agree to give fixed or floating interest rate as they do in common bonds for the funds of investor. To compensate for having additional value through the option to convert the bond to stock, a convertible bond typically has a coupon rate lower than that of similar, non-convertible debt. The investor receives the potential upside of conversion into equity while protecting downside with cash flow from the coupon payments and the return of principal upon maturity. These properties—and the fact that convertible bonds trade often below fair value—lead naturally to the idea of convertible arbitrage, where a long position in the convertible bond is balanced by a short position in the underlying equity.
From the issuer's perspective, the key benefit of raising money by selling convertible bonds is a reduced cash interest payment. The advantage for companies of issuing convertible bonds is that, if the bonds are converted to stocks, companies' debt vanishes. However, in exchange for the benefit of reduced interest payments, the value of shareholder's equity is reduced due to the stock dilution expected when bondholders convert their bonds into new shares.
Convertible notes are also a frequent vehicle for seed investing in startup companies, as a form of debt that converts to equity in a future investing round. It is a hybrid investment vehicle, which carries the protection of debt at the start, but shares in the upside as equity if the startup is successful, while avoiding the necessity of valuing the company at too early a stage.

Types

Underwriters have been quite innovative and provided several variations of the initial convertible structure. Although no formal classification exists in the financial market it is possible to segment the convertible universe into the following sub-types:

Vanilla convertible bonds

Vanilla convertible bonds are the most plain convertible structures. They grant the holder the right to convert into a certain number of shares determined according to a conversion price determined in advance. They may offer coupon regular payments during the life of the security and have a fixed maturity date where the nominal value of the bond is redeemable by the holder. This type is the most common convertible type and is typically providing the asymmetric returns profile and positive convexity often wrongly associated to the entire asset class: at maturity the holder would indeed either convert into shares or request the redemption at par depending on whether or not the stock price is above the conversion price.

Mandatory convertibles

Mandatory convertibles are a common variation of the vanilla subtype, especially on the US market. Mandatory convertible would force the holder to convert into shares at maturity—hence the term "Mandatory". Those securities would very often bear two conversion prices, making their profiles similar to a "risk reversal" option strategy. The first conversion price would limit the price where the investor would receive the equivalent of its par value back in shares, the second would delimit where the investor will earn more than par. Note that if the stock price is below the first conversion price the investor would suffer a capital loss compared to its original investment. Mandatory convertibles can be compared to forward selling of equity at a premium.

Reverse convertibles

Reverse convertibles are a less common variation, mostly issued synthetically. They would be opposite of the vanilla structure: the conversion price would act as a knock-in short put option: as the stock price drops below the conversion price the investor would start to be exposed the underlying stock performance and no longer able to redeem at par its bond. This negative convexity would be compensated by a usually high regular coupon payment.

Packaged convertibles

Packaged convertibles or sometimes "bond + option" structures are simply a straight bonds and a call option/warrant wrapped together. Usually the investor would be able to then trade both legs separately. Although the initial payoff is similar to a plain vanilla one, the Packaged Convertibles would then have different dynamics and risks associated with them since at maturity the holder would not receive some cash or shares but some cash and potentially some share. They would for instance miss the modified duration mitigation effect usual with plain vanilla convertibles structures.

Contingent convertibles

Contingent convertibles are a variation of the mandatory convertibles. They are automatically converted into equity if a pre-specified trigger event occurs, for example if the value of assets is below the value of its guaranteed debt.

Foreign currency convertibles

Foreign currency convertibles are any convertible bonds whose face value is issued in a currency different from issuing company's domestic currency.

Additional features

Any convertible bond structure, on top of its type, would bear a certain range of additional features as defined in its issuance prospectus:
Convertibles could bear other more technical features depending on the issuer needs:
Due to their relative complexity, convertible bond investors could refer to the following terms while describing convertible bonds:
The global convertible bond market is relatively small, with about 400 bn USD, as a comparison the straight corporate bond market would be about 14,000 bn USD. Among those 400 bn, about 320 bn USD are "Vanilla" convertible bonds, the largest sub-segment of the asset class.
Convertibles are not spread equally and some slight differences exist between the different regional markets:
Convertible bond investors get split into two broad categories: Hedged and Long-only investors.
The splits between those investors differ across the regions: In 2013, the American region was dominated by Hedged Investors while EMEA was dominated by Long-Only investors. Globally the split is about balanced between the two categories.

Valuation

In theory, the market price of a convertible debenture should never drop below its intrinsic value. The intrinsic value is simply the number of shares being converted at par value times the current market price of common shares.
The 3 main stages of convertible bond behaviour are:
In-the-money CB's are considered as being within Area of Equity. At-the-money CB's are considered as being within Area of Equity & Debt. Out-the-money CB's are considered as being within Area of Debt
From a valuation perspective, a convertible bond consists of two assets: a bond and a warrant. Valuing a convertible requires an assumption of
  1. the underlying stock volatility to value the option and
  2. the credit spread for the fixed income portion that takes into account the firm's credit profile and the ranking of the convertible within the capital structure.
Using the market price of the convertible, one can determine the implied volatility or implied spread.
This volatility/credit dichotomy is the standard practice for valuing convertibles. What makes convertibles so interesting is that, except in the case of exchangeables, one cannot entirely separate the volatility from the credit. Higher volatility tends to accompany weaker credit. In the case of exchangeables, the credit quality of the issuer may be decoupled from the volatility of the underlying shares. The true artists of convertibles and exchangeables are the people who know how to play this balancing act.
A simple method for calculating the value of a convertible involves calculating the present value of future interest and :wikt:principal|principal payments at the cost of debt and adds the present value of the warrant. However, this method ignores certain market realities including stochastic interest rates and credit spreads, and does not take into account popular convertible features such as issuer calls, investor puts, and conversion rate resets. The most popular models for valuing convertibles with these features are finite difference models as well as the more common binomial- and trinomial trees. However, also valuation models based on Monte Carlo methods are available.
Since 1991–92, most market-makers in Europe have employed binomial models to evaluate convertibles. Models were available from INSEAD, Trend Data of Canada, Bloomberg LP and from home-developed models, amongst others. These models needed an input of credit spread, volatility for pricing, and the risk-free rate of return. The binomial calculation assumes there is a bell-shaped probability distribution to future share prices, and the higher the volatility, the flatter is the bell-shape. Where there are issuer calls and investor puts, these will affect the expected residual period of optionality, at different share price levels. The binomial value is a weighted expected value, taking readings from all the different nodes of a lattice expanding out from current prices and taking account of varying periods of expected residual optionality at different share price levels. See Lattice model #Hybrid Securities. The three biggest areas of subjectivity are the rate of volatility used, for volatility is not constant, and whether or not to incorporate into the model a cost of stock borrow, for hedge funds and market-makers. The third important factor is the dividend status of the equity delivered, if the bond is called, as the issuer may time the calling of the bond to minimise the dividend cost to the issuer.

Risk

Convertible bonds are mainly issued by start-up or small companies. The chance of default or large movement in either direction is much higher than well-established firms. Investors should have a keen awareness of significant credit risk and price swing behavior associated with convertible bonds.  Consequently, Valuation models need to capture credit risk and handle potential price jump.

Uses for investors

In consequence, since we get, which implies that the variation of C is less than the variation of S, which can be interpreted as less volatility.

Lower fixed-rate borrowing costs

Source: Bloomberg