What are convertible bonds?
A convertible bond is a bond with an embedded option to convert into shares.
Why convertible bonds?
For all of you Hannah Montana fans out there, convertible bonds offer the “best of both worlds” for investors in the sense that they posssess the superior protection of a senior security in addition to the opportunity to take common stock if the value rises. Naturally, one must wonder, shouldn’t they be the worst of both worlds on the other side for issuers and their shareholders? After all, it seems that when the firm languishes, the investor keeps the senior security with its income and liquidition preferences while shareholders get almost nothing. And when the issuer prospers, the investor converts at a bargain price, sharing in the prosperity.
The Convertible Bond Continuum
Generally, there are 3 types of convertible bonds: 1) bond-like convertibles, 2) balancd convertibles, and 3) equity-like or in-the-money convertibles. Each bond changes categories as its equity price fluctuates
1) Bond-like converts:
These converts behave effectively like straight bonds and possess the least equity sensitivity of the 3 types. Busted converts often provide attractive yields as the issues age and approach maaturity. Most convertible debt is held by convertible arbitrage investors who try to exploit the pricing inefficiencies between the 2 markets by going long the convertible and short the equity. Once a convertible bond is “busted” (like when the underlying equity falls significantly below the conversion price), it becomes more debt-like and arbitrage investors will look to cover their short positions aand sell the convertibles.
2) Balanced Converts:
The classic scnario in which the converts have both fixed income and equity characteristicss — their value rises and falls based on changes to the underlying stock price. The debt-like structure creates a floor value. Often new issues have an asymmetric payoff profile in the sense they can capture ~50% of the underlying’s upside while only around 30% of the stock’s downside.
3) In-the-Money Converts:
In-The-Money Convertibles behave like equity instruments, with the bulk of their value derived from changes in price of the underlying stock.