What are Convertible Bonds?
Written by Rick Welch
Is a convertible bond a fixed income or equity security? The answer is they can be both, but not at the same time. As defined “a convertible bond is a corporate bond with an embedded call option that allows the owner to convert the bond into the common stock of the issuing company at a certain date in the future. The number of shares into which the bond can be converted and the conversion price are both set at time of issuance.” When convertible bonds mature, they can be redeemed at their face value or converted at the market value of the underlying common stock. Convertibles can be converted at the option of the investor or by the issuing company through a forced conversion. The bond features of convertible bonds come from the obligation of the issuer to repay the bondholder a specified sum of money (the coupon) at specific time intervals and to repay the principal amount of the loan at maturity. The stock features come from the embedded call option that allows the bond to be converted into equity should the price of the underlying stock rise. The value of the call option is derived from its two components: intrinsic value (the difference between the market price of the underlying stock and the option strike price) and time value, which is greatest at time of writing and zero at expiration.
This is how convertible bonds work. If the price of the underlying stock rises above the option strike price, then the value of the call option increases and the convertible itself is said to be in the money. In this example the investor has purchased a bond but is still able to participate in and benefit from a rising equity market. If, on the other hand, the price of the underlying stock falls below the option strike price then the value of the call option decreases and the convertible is out of the money. In this case we see the downside protection offered by a convertible bond in that the convertible still maintains the value of the bond floor, which is the value of a traditional bond (with same coupon, maturity and credit rating) without a conversion feature. It is this combination of equity-like performance in rising markets and protection during falling ones that makes convertible bonds a compelling asset class which can provide attractive future risk-adjusted investment returns.
In this current period of rising interest rates, we will continue to maintain a “low to the ground” approach to bond portfolio duration with a target duration of under 5 years. In the case of convertibles, we focus on effective duration which measures the sensitivity of the price of a bond with or without embedded options to changes in interest rates, taking into account the likelihood of the bond being called prior to maturity. The average duration of the convertibles market is under 3 years. Convertible bonds have performed well during the past 8 periods (dating back to 1993) in which the 10-year US Treasury yield rose at least 100 bps. During these periods, convertibles recorded an average return of +19.13%, compared to an average return in the S&P 500 of +16.34%. Diversification of an investment grade bond portfolio can be improved by the addition of convertible bonds, which have negative correlation (-0.31) with US Treasury Bonds and low correlation (0.15) with the Barclays US Aggregate Bond Index. Negative correlation between investments means that their prices move in opposite directions in response to different market forces. Low correlation means that prices may move in the same direction (perhaps at different rates) or not.