What is it?
- A bond that can be converted into a predetermined amount of the company’s common stock at a substantial premium to its market value, at certain times during its life, usually at the discretion of the bondholder.
How is it constructed?
- A bond with a stock call option hidden inside. Offers lower yield on the bond in exchange for optionality to convert to equity if underlying rise.
- 4 elements determines convertible price:
1. Bond value: affected by credit spreads, interest rates, investor puts and issuer calls.
2. Option value: the time value of embedded option to convert and affected by volatility expectations, strike, parity, issuer call, interest rate, dividend.
3. Parity: the value of underlying shares if investor converts and affected by underlying share price, adjustment to conversion teams during issue’s life and FX changes.
4. Yield advantage: yield of convertible – dividend of underlying share.
What is payoff ?
When is it used?
- Used by hedge investors to extract value from any cheapness in the convertible’s option or seek to gain value from tightening credit spreads.
- Used by equity investors that seek yield advantage and downside protection from the low cost put option.
- Used by outright convertible investors that prefer balanced convertibles on stronger credit names, which give exposure to parity rises, along with downside protection from stable bond value.
- Used by balanced funds with a diversified portfolio.
- Used by fixed income investors looking for higher spread compared to straight debt, with upside potential from the low cost embedded option.
- Used by distressed funds that will invest in convertibles either as they believe the company will negotiate through the current difficulties or in order to participate in a debt for equity swap.
What are the benefits?
- Downside support with upside participation.
- Investors could delta-hedge via shorting stock, which leaves them with long gamma position that will gain as volatility goes up. Meanwhile a return from risk-free interest rate plus credit spread is guaranteed from the unhedged portion (bond).