Convertible bond

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).
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