Convertible Bond
Security which is issued by a company as a means of raising money
What is a Convertible Bond?
A convertible bond is a hybrid financial instrument that features a fixed-income asset and a derivative. It is issued by a company and gives the holder the right to exchange an agreed-upon number of shares of the company’s stock in the future.
On the capital structure, they are between debt and equity as they include elements of both. They are typically structured as a bond with an embedded stock option with the issuing company’s stock as the underlying.
Versatile and practical, they offer a unique blend of debt and equity characteristics. These financial instruments provide companies with a flexible approach to satisfy their financing needs and help raise capital.
Convertible bonds are not new instruments. Their history traces back to the late 19th century when railroads first used them to raise capital when direct equity was not an option.
In the latter 20th century, the introduction of the Black-Scholes model lent legitimacy to the work of option traders and option exchanges. This has led to developments in risk management techniques and analysis of other securities, such as convertible bonds, and proliferated their use.
- Convertible bonds are debt instruments that can be converted into equity at a later stage. They are hybrid instruments that behave like debt and equity.
- Companies typically issue convertible bonds to pay lower interest rates to help with their cash flow. Investors buy them to have exposure to the upside.
- During certain time intervals defined by the covenants, investors can exercise convertible bonds.
- Typical convertible bond risks are interest rate risk, credit risk, equity risk, and implied volatility risk.
Understanding Convertible Bonds
At its core, a convertible bond represents a contract between an issuer and an investor, embodying debt and equity securities elements. They offer investors the option to exchange their debt with equity at a future date, contingent upon specified triggers or events.
Some fundamental elements that we need to know for the convertible bonds are:
- Conversion rate (Cr): Number of stocks received if converted to equity
- Face value (FV): The nominal face value of the bond that the interest is calculated
- S: The underlying stock price.
- B: Price of the pure bond
- Bond floor (BF): The intrinsic value of the bond component.
- Bond premium (BF): The percentage amount the security is trading above the bond floor.
- Parity premium (Pa): The percentage amount the security is trading above the strike price.
- Strike price (K): Face value divided by conversion rate.
For a zero-coupon convertible bond, at maturity, the payoff will be max(FV, Cr x S). We can rewrite the expression as
FV + max(0, Cr x S - FV)
Further rewriting it, we get
Cr x max(0, S - FV/Cr)
The payoff resembles the Cr number of call options with a strike price of FV/Cr.
If the conversion is only possible at maturity, we can gather essential results from it. In that case, max(0, Cr x S - FV) describes a European call option. And we can price the note as
price P = B + CallEuropean.
As we have shown that the convertible bond is the sum of a bond and an option, we can argue its behavior will depend on the underlying. If the stock price is very high (deep in the money), its price will reflect the option. If the stock price is very low, the price will be close to the bond.
Most convertible bonds, though, are issued with the possibility of early exercise. In that case, they are similar to American call options. Still, if the underlying is a non-dividend stock, the investors will not exercise their notes until maturity, similar to an American call option.
This also means that if the dividend is high enough, holders of the convertible bonds may elect to exercise their right and exchange their notes for the equity, again like an American call option.
Covenants/conditions could determine the exercise time. Also, many convertible bonds are typically callable. A callable bond is a type of debt that the issuer can, at a certain time, buy back from the investors at a predetermined price.
So, unlike a pure call option on a non-dividend-paying underlying, convertible holders might be forced to exercise their notes early if they are called.
Why Use Convertible Bonds?
The convertible's flexibility allows the firm to create a security between debt and equity. Here are some of the considerations and features of convertibles.
Cost of Debt
As the holder is receiving an option with the company's stock as underlying, under a competitive market, this will result in a lower coupon rate or yield to maturity for the pure bond. This might be advantageous for a company that would like to minimize its exposure to cash flow risk.
For instance, if the company is experiencing an uncertain economic situation in the near term, it may want to reduce its interest payment risk by issuing convertible bonds. This will allow pressure relief; however, it is not for free.
It may be tempting to think that by issuing convertible bonds, the company is lowering its cost of debt. However, this is incorrect. It is important to remember that by paying less interest, the company is giving away an upside by issuing an option.
This means that the cost of the hybrid is not lower than debt; it is, in fact, higher. This is intuitive to observe by imagining two convertible bonds, one with a higher coupon rate and one with a lower one. The lower coupon rate is only possible by having a higher conversion rate, Cr.
The higher conversion rate means a lower equivalent strike price. As a result, the convertible will behave more like an in-the-money option comparatively, more equity-like. Consequently, it will have a higher cost.
Dilution
In the case of exercise, earnings per share will decrease, and previous shareholders will be diluted. This is an important consequence of convertible bonds. In fact, when calculating the diluted earnings per share, all outstanding equity-like debt, including warrants, will be considered.
Convertible will affect the share price upon announcement, depending on how it is structured. For low conversion rates, the price move will be insignificant. However, for large conversion rates, share prices tend to decrease. This is again due to equity-like behavior.
Monetization of Risk
From a fundamental definition of risk, a risky company’s stock is expected to be relatively more volatile. As it’s more risky, lenders would demand a higher interest rate.
One way to reduce the interest rate would be to trade the excess volatility for a lower rate. If the company is publicly listed, we can assume that the stock’s volatility and price will be efficient. Therefore, the company can trade volatility for interest payments.
Reducing yield to maturity by giving away an option effectively means trading volatility for interest payments. The company practically receives money for volatility.
Optimizing the Capital Structure
Having a security between debt and equity, the company can allocate its capital structure more precisely. The optimal capital structure of a company will reflect its risk aversion and will be specific to that company.
Risk preferences will depend on the industry sector and economic outlook, among other things. Convertibles could allow the company to shape its risk profile more efficiently.
Benefits of Investing in Convertible Bonds?
Combining the behavior of a bond and an option, convertibles are versatile instruments. They provide investors with important advantages. Some of the benefits are:
- Fixed income exposure: Convertible bonds offer investors regular interest payments and a steady stream of income similar to traditional bonds.
- Potential for capital appreciation: By converting the bonds into equity shares, investors have the opportunity to benefit from any future increase in the issuer's stock price.
- Risk mitigation: The bond component of convertible bonds provides downside protection in the event that the issuer's stock price declines, offering investors a degree of safety compared to pure equity investments.
- Regulatory advantage: Fixed-income-only funds can still be exposed to equities.
Conclusion
Convertible bonds give exposure to debt and equity. This allows investors to be exposed to the company's whole balance sheet. By holding such a security, investors face various types of risk.
Convertibles are exposed to interest rate, credit, equity, and implied volatility risks. Thus, they are fairly sophisticated instruments from a risk management point of view.
The advantage for the issuers is that they trade at lower YTM and are charged a lower interest rate compared to an equivalent vanilla bond, as the underwriter is giving up the upside. The lower the strike price or higher the conversion rate, the lower the yield the bond part should carry.
Lower interest payments help with financing as they alleviate cash flow requirements. However, the cost of debt is technically higher than the charged interest rate as the underwriter has allowed exposure to equity.
Convertible bonds, being both bond-like and equity-like, will affect the company's related metrics. They are typically included in dilution analysis and considered when calculating diluted shares. Accordingly, convertibles also impact diluted earnings per share.
Typically, convertible bonds have additional covenants to protect investors from rare events. For instance, in the case of an acquisition, if the company accepts an offer for a cash buyout, the convertible bond’s value will plummet due to the disappearance of implied volatility.
This will still be the case even if the offer is significantly higher than the current share price. In this case, the acquisition price will fall to the bond floor if it is less than the strike price or to the intrinsic option price if it is higher.
Covenants and conditions called ratchets protect companies from such events. They can also discourage hostile takeovers by imposing conditions such as lower conversion rates in the case of a hostile M&A action.
Convertible Bonds FAQs
When an investor purchases a convertible bond, they receive periodic interest payments, similar to traditional bonds. However, if the investor chooses to convert their bond into equity, they can do so at the predetermined conversion ratio.
Some of the risks associated are interest rate risk, credit risk, equity risk, and implied volatility risk.
The price of a convertible bond is determined by the combination of its bond value and the value of the embedded option.
Companies commonly issue convertible bonds with relatively high growth potential that may have difficulty accessing traditional equity financing.
These may include technology firms, biotechnology companies, and other growth-oriented businesses.
Convertible bonds differ from traditional bonds in that they offer the potential for capital appreciation through conversion into equity. They also differ from common stocks in that they provide fixed income through interest payments and have priority over common shareholders.
Convertible bonds may be callable, meaning that the issuer has the option to redeem the bonds before their scheduled maturity date. If called, bondholders may receive a predetermined call price, typically at a premium to the bond's face value.
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