History and Charakteriska of Convertible Bonds
Definition of a convertible bond
Convertible bonds are bonds, which entail the right to convert the bonds into the underlying security at a predefined ratio (conversion ratio). This feature leads to profits should the underlying security rise in price. It is obvious that such a right is not given for free. The yield of a convertible bond at issue is typically below the yield of a bond, which is the price one pays for the participation. (Clearly defined cost in contrast to theoretically unlimited yield).
We define a convertible bond as:
Bond with a call option on a stock
Stock with a put option at redemption
From a bondholders point of view is the yield smaller because of the call option; from a shareholders point of view has the stock a premium because of the put option.
Risk Management: Option and Bond Part
Convertible bond and share price: four characteristics
The convertible bond will change its characteristics, dependent on the share price development after issuance. The different phases are defined as follows:
Focus on Hybrid Part of Life Cycle
Distressed Convertibles
Bonds with very high yield, corresponding to the inherent risk. The share price as well as the credit quality of the issuing company is developing unfavourably to the investor. These convertible bonds we find only in the non-investment grade segment of the market.
Bond Proxies
Although the share price is developing unfavourably, the bond will not fall below a certain level; this level is defined by the yield of the convertible bond (bond floor). It has to be said that this is only the case with issuers of good credit quality. The share price movement does not matter anymore, since the exercise price of the call option is deep out-of-the-money.
Hybrid convertibles
Newly issues convertibles are almost always to be found in this segment. Share price as well as interest rate developments have a large influence on the value of the convertible bond. This is the segment where most high gamma convertibles can be found; those convertibles, which because of their asymmetric participation on the share price development have the most interesting risk return profile.
Equity Proxies
As already implied in its name, equity proxies are moving basically in line with its stock price. The share price has risen strongly after issuance, which on the one hand leads to premium erosion and on the other hand to a move away from the bond floor. Such issues can be used as share replacements, if the inherent yield is bigger than the one of the stock. Such convertibles also offer a considerable added value if the stock has big movements, because the put option (redemption) still offers good protection.
Different structures
The classic convertible bond is issued by company X and is convertible into equities of this company. As such, share price development and credit risk are coupled.
The exchangeable bond is issued by a company X, but is convertible into equities of company Y.So the share price development and the credit risk have to be viewed separately.
Synthetic convertibles are issued by an investment bank and are normally not cheap. Often it is not easy to identify theses synthetics as such, and hence it is necessary to read the prospectus of the issue carefully.
All these structures can additionally be issues as discount bonds. Discount bonds are issued at a lower price than the redemption price. In particular cases such bonds must not even carry a coupon, they are also called zero-coupon-bonds. The yield is calculated to maturity, in some cases to the put date. The advantage for the issuing company is clear: It has no interest payments on its debt, and if the share price moves up, the company has issued debt at very favourable conditions. The danger with these issues is that the possible loss potential often is underestimated after the shares have had a good run. On the other hand it can happen that the higher redemption price is not taken into consideration when looking at the valuations.
Premium
The number of shares, which can get through conversion, is dependent on the conversion ratio. If the ratio is multiplied by the actual share price, the result is the share price part of the convertible bond, also called parity. The premium is the difference between the market price of the convertible bond and its parity and is usually quoted in percentage terms. It is often used to roughly assess the share price sensitivity of a convertible bond, without neglecting the volatility of the shares.
Risk premium
To define the risk premium of a convertible bond, we have to calculate the bond floor first. The bond floor is equivalent to the value where a convertible bond offers the same yield as a comparable straight bond. If there are no comparable straight bonds, the credit default swap market (CDS) is a good tool to check the credit quality of the issuer to value the bond. The CDS market has been a reliable indicator for a number of years, especially in the investment grade segment.
The risk premium is the difference between bond floor and the market value of the convertible bond and is named as such, since the convertible should not fall below the bond floor even with heavy sell off in equity markets. In practice however it can be seen that the bond floor is only a reliable level for investment grade issues. Changing corporate spreads as well as the interest rate environment ask for a continuous monitoring of the bond floor.
The Call
The call of a convertible bond enables the issuer to redeem the convertible bond prior to its redemption date. This is very important for the investor, since it shortens the time period of the option and also the possibility to convert the bond into shares. There is a softer form of the call, the so-called soft call. In this case it is only for the issuer possible to call the bonds, if certain predetermined conditions are fulfilled. The most common condition is a minimum level of the underlying share price.
The Put
The put of a convertible bond enables the holder to redeem the convertible prior to its redemption date at a pre-determined price. A put therefore shortens the life of a convertible bond (theoretically), and lowers the credit- and interest rate risk for the investor (lower duration). If a convertible at around the time of the put option trades at the level of the put-price, it is recommended to sell the convertible, since the additional downside protection will not be there anymore and will only be there after a certain time period respectively.
The Delta
Delta shows the sensitivity of convertible bond with respect to the underlying share. Using delta leads to precise predictions as to how the convertible bond will behave (given the correct calculation of delta). In order to calculate the correct delta, it is essential to use the correct volatility as well as the correct credit spreads. Using wrong calculated deltas can lead to unexpected losses, especially for hedge accounts.
The Gamma
Gamma is a measure of the change of delta. It is a parameter which does not get enough attention. As investors we favour the so-called high-gamma-convertibles, as these bonds offer the best risk reward profile. The reason is simple: In case of rising stock prices a high gamma convertible will also increase the delta and hence the participation will increase. With falling stock prices the delta will be reduced quickly and the capital protection kicks in quicker. This asymmetric behaviour is the essential added value of the convertible bond as well of a corresponding convertible bond portfolio.