Convertible bond

In finance, a convertible bond, convertible note, or convertible debt (or a convertible debenture if it has a maturity of greater than 10 years) 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 (limited) 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.
Although no formal classification exists in the financial market it is possible to segment convertibles into the following sub-types:
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 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. If the stock price is below the first conversion price the investor would suffer a capital loss compared to its original investment (excluding the potential coupon payments). Mandatory convertibles can be compared to forward selling of equity at a premium.
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 or sometimes "bond + option" structures are simply a straight bond 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 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 are any convertible bonds whose face value is issued in a currency different from issuing company's domestic currency.
Exchangeable bond where the issuing company and the underlying stock company are different companies (e.g. XS0882243453, GBL into GDF Suez). This distinction is usually made in terms of risk i.e. equity and credit risk being correlated: in some cases the entities would be legally distinct, but not considered as exchangeable as the ultimate guarantor being the same as the underlying stock company (e.g. typical in the case of the Sukuk, Islamic convertible bonds, needing a specific legal setup to be compliant with the Islamic law).
Synthetically structured convertible bond issued by an investment bank to replicate a convertible payoff on a specific underlying equity. Sometimes referred also as Cash settled Bank Exchangeable Bonds (e.g. Barclays/MSFT 25 US06738G8A15 - Barclays Bank PLC is the issuer while Microsoft is the referenced underlying equity). Most reverse convertibles are synthetics. Synthetics are more similar to structured products with settlement done in cash and no equities being produced as the result of a conversion. The Packaged Convertibles (e.g. Siemens 17 DE000A1G0WA1) are sometimes confused with synthetics due to the fact an issuer (sometime a portfolio manager) will create a structure using straight bonds and options. There are in reality two completely different products with different risks and payoffs.
Convertibles may have other features, such as:
The global convertible bond market is relatively small, with about 400 billion USD (as of Jan 2013, excluding synthetics). As a comparison, the straight corporate bond market would be about 14,000 billion USD. Among those 400 billion, about 320 billion 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 (about 60%) while EMEA was dominated by Long-Only investors (about 70%). Globally the split is about balanced between the two categories.
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:
From a valuation perspective, a convertible bond consists of two assets: a bond and a warrant. Valuing a convertible requires an assumption of
Using the market price of the convertible, one can determine the implied volatility (using the assumed spread) or implied spread (using the assumed volatility).
This volatility/credit dichotomy is the standard practice for valuing convertibles. What makes convertibles so interesting is that, except in the case of exchangeables (see above), one cannot entirely separate the volatility from the credit. Higher volatility (a good thing) tends to accompany weaker credit (bad). 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 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 trees 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 (historic volatility often used), 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, (1) taking readings from all the different nodes of a lattice expanding out from current prices and (2) taking account of varying periods of expected residual optionality at different share price levels. The three biggest areas of subjectivity are (1) the rate of volatility used, for volatility is not constant, and (2) whether or not to incorporate into the model a cost of stock borrow, for hedge funds and market-makers. The third important factor is (3) 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.
Convertible bonds are mainly issued by startup 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 jumps.
In consequence, since 0 < Δ < 1 {\displaystyle 0<\Delta <1} we get δ C < δ S {\displaystyle \delta C<\delta S} , which implies that the variation of C is less than the variation of S, which can be interpreted as less volatility.
Convertible bonds allow issuers to issue debt at a lower cost. Typically, a convertible bond at issue yields 1% to 3% less than straight bonds.
For a finance director watching the trend in interest rates, there is an attraction in trying to catch the lowest point in the cycle to fund with fixed rate debt, or swap variable rate bank borrowings for fixed rate convertible borrowing. Even if the fixed market turns, it may still be possible for a company to borrow via a convertible carrying a lower coupon than ever would have been possible with straight debt funding.
Similarly, the conversion price a company fixes on a convertible can be higher than the level that the share price ever reached recently. For example, compare the equity dilution on a convertible issued on a 20 or 30% premium to the higher equity dilution on a rights issue, when the new shares are offered on a 15 to 20% discount to the prevailing share price.
With a convertible bond, dilution of the voting rights of existing shareholders only happens on eventual conversion of the bond. However convertible preference shares typically carry voting rights when preference dividends are in arrears. Of course, the bigger voting impact occurs if the issuer decides to issue an exchangeable rather than a convertible.
Convertibles can be used to increase the total amount of debt a company has in issue. The market tends to expect that a company will not increase straight debt beyond certain limits, without it negatively impacting upon the credit rating and the cost of debt. Convertibles can provide additional funding when the straight debt “window” may not be open. Subordination of convertible debt is often regarded as an acceptable risk by investors if the conversion rights are attractive by way of compensation.
For countries, such as the UK, where companies are subject to limits on the number of shares that can be offered to non-shareholders non-pre-emptively, convertibles can raise more money than via equity issues. Under the UK's 1989 Guidelines issued by the Investor Protection Committees (IPCs) of the Association of British Insurers (ABI) and the National Association of Pension Fund Managers (NAPF), the IPCs will advise their members not to object to non pre-emptive issues which add no more than 5pct to historic non-diluted balance sheet equity in the period from AGM to AGM, and no more than 7.5pct in total over a period of 3 financial years. The pre-emption limits are calculated on the assumption of 100pct probability of conversion, using the figure of undiluted historic balance sheet share capital (where there is assumed a 0pct probability of conversion). There is no attempt to assign probabilities of conversion in both circumstances, which would result in bigger convertible issues being permitted. The reason for this inconsistency may lie in the fact that the Pre Emption Guidelines were drawn up in 1989, and binomial evaluations were not commonplace amongst professional investors until 1991–92.
Premium redemption convertibles such as the majority of French convertibles and zero-coupon Liquid Yield Option Notes (LYONs), provide a fixed interest return at issue which is significantly (or completely) accounted for by the appreciation to the redemption price. If, however, the bonds are converted by investors before the maturity date, the issuer will have benefited by having issued the bonds on a low or even zero-coupon. The higher the premium redemption price, the more the shares have to travel for conversion to take place before the maturity date, and the lower the conversion premium has to be at issue to ensure that the conversion rights are credible.
Convertibles have a place as the currency used in takeovers. The bidder can offer a higher income on a convertible than the dividend yield on a bid victim's shares, without having to raise the dividend yield on all the bidder's shares. This eases the process for a bidder with low-yield shares acquiring a company with higher-yielding shares. Perversely, the lower the yield on the bidder's shares, the easier it is for the bidder to create a higher conversion premium on the convertible, with consequent benefits for the mathematics of the takeover. In the 1980s, UK domestic convertibles accounted for about 80pct of the European convertibles market, and over 80pct of these were issued either as takeover currency or as funding for takeovers. They had several cosmetic attractions.
The market for convertibles is primarily pitched towards the non taxpaying investor. The price will substantially reflect the value of the underlying shares, the discounted gross income advantage of the convertible over the underlying shares, plus some figure for the embedded optionality of the bond. The tax advantage is greatest with mandatory convertibles. Effectively a high tax-paying shareholder can benefit from the company securitising gross future income on the convertible, income which it can offset against taxable profits.
Source: Bloomberg