Investment Product Review

 

In this series we examine investment products and strategies, from the mundane to the highly complex, explaining how they work and why we do or do not use these particular products or strategies in our portfolios.

Convertible Bonds: A Hybrid Security

A convertible bond is a hybrid debenture1 bond issued by corporations that combines a normal coupon-paying bond with an option to convert that bond into a pre-specified amount of that company’s common stock.  The embedded option2 gives the holder the ability to convert the par value of the bond into common equity at a given strike price.  For example, suppose the bond had a par value of $1000 (which is the standard denomination) and a strike price of $50 per share.  This would mean that the bond could be converted into 20 shares of stock ($1000 divided by the strike price of $50).  This number is known as the conversion ratio.

UnivComp

The embedded option of convertibles results in properties associated with both fixed income and equity securities.  Whether the convertible valuation moves more like a stock or a bond depends on where the market price of the stock is relative to the strike price.  Continuing with our example above, assume the stock price is currently $25 a share.  This price would render the option essentially worthless, as the strike price would require converting the bond to the stock at a value that was double the current stock price.  In this case, the convertible would be priced almost entirely as a fixed income security, where the price was a function of factors like coupon rate, time to maturity, and market interest rates.  If, on the other hand, the current stock price were $75 per share, the option would be extremely valuable, as the bond could be converted at a rate that was $25 below the market price for each share, allowing the holder to convert and sell the shares for an instant profit.  In this case, the price of the convertible will be far more dependent on the movement of the underlying stock than on its bond-like characteristics.  As the market price of the stock approaches the strike price of the option, the convertible price will react to factors affecting both stocks and bonds.  Upon issuance, the strike price is generally set well above the current market price of the stock.

Aside from the above-mentioned features, convertibles have other risks that need to be understood.  In the case of bankruptcy, convertibles are subordinate to senior and secured debt, but are senior to preferred and common equity.  Along with the effect of the option on the security price, this implies that convertibles are subject to more company-specific risk than a regular corporate bond, but less than that of equity.  Also, many convertibles include a “call” feature, meaning the issuer has the ability to repurchase the bond before maturity at a pre-specified price.  This is detrimental to bondholders, because it caps the upside value of the convertible.  If the value of the convertible increases above the call price, it is likely to be called by the issuer, limiting the possible return for the investor.

At first glance, convertible bonds appear to be an extremely attractive security.  They offer unlimited upside potential (through the embedded option) along with downside protection (though the bond itself).  However, as the above discussion outlines, convertibles are subject to a unique set of risks, and often do not offer the return potential that they initially appear to.  Further, as the price of the underlying stock moves, the properties of the convertible vary, meaning the overall allocation of the portfolio can shift if this movement is not specifically addressed.  Investors in convertibles should be conscious of the risks involved with this type of security, and understand exactly where they fit in an investment portfolio.

References
1. A debenture is an unsecured debt obligation issued by a corporation (as opposed to debt with explicit collateral, such as an asset-backed security).
2. For more information on options, see our previous blog post: http://www.empirical.net/derivatives-option-contracts-part-2/

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About Erik Lehr

Erik graduated from the University of Oregon with a Bachelor of Economics and Mathematics degree. His background includes master’s degree in economics and a Master of Science in Computational Finance and Risk Management from the University of Washington. Erik also holds the Chartered Alternative Investment Analyst (CAIA®) designation.

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