Mark Wightman of SunGard explains the key features and characteristics of convertible bonds, and looks at the drivers, risks and other considerations when investing in these products.
Date: Feb 2011
Tags: Bond, Fixed income, Convertible bonds, Equities, Coupon
The conversion price is at a premium to the share price when the bond is issued, he added.
So when a convertible bond is issued in today’s markets, it is common to see terms that enable investors to only convert into the underlying stock if the share price is 30% to 40% above the share price at the time of issue.
Other key terms
Convertibles are fixed income securities, said Wightman, so have a fixed redemption date and a fixed coupon, in most cases.
The conversion period might be limited, he added, so investors might only be able to convert at some point in the future if the share price is above a certain level.
There also tends to be an issuer call, said Wightman, giving the bond issuer an option to call the bond back, often at par, at some point in the future – either based on certain time limit, or linked to a share-price trigger, for example a 130% trigger level.
Some Asian convertible bonds also have a put option, he added, enabling the investor to sell the bond back to the company at a specific price at a point in the future.
Why buy convertible bonds
Convertibles are hybrid products, so have characteristics of both equity and debt. Investors therefore get some element of downside protection in terms of the bond, explained Wightman, but also get potential equity participation through this option.
When assessing market conditions in relation to the suitability of convertible bonds – he said that various factors need to be considered.
If an investor is 100% sure that a company’s share price will rise, for example, then it makes sense for them to buy the equity directly. On the flipside, if an investor thinks the share price might go down but they like the name and they want an attractive coupon, then they might opt for the safety of a bond itself – which is also higher within the capital structure of a company in the event of a default.
A convertible bond, therefore, sits between these two options, said Wightman.
Investors don’t get the same coupon as with a straight bond issue, but there is the potential to convert into the shares at some point in the future.
Factors influencing valuations
According to Wightman, convertibles are more complicated given their debt and equity characteristics.
An equity option is driven by the share price, in terms of how close an instrument is to the strike price, and by volatility; the valuation of a bond is driven by the company’s creditworthiness as well as by interest rates.
So when looking at how convertibles will respond to different movements in the market, he explained that if the share price rises, the bond price will tend to follow. Equally, if volatility increases, the bond price will typically rise also.
However, if creditworthiness decreases, this will have a negative impact on the convertible bonds – as will rising interest rates.
In terms of other risks and issues for people to consider, Wightman said that while many convertible bonds are US dollar-denominated, they might convert into shares of the company in a local currency.
In these cases, there is an exchange rate risk, and people should look at whether the rate is fixed – which is often is – or at whether it floats at the current spot price.
Weigh one convertible bond against another
As with any investment, Wightman said investors should look closely at the underlying story of a company when assessing whether to buy a convertible bond.
Within the Asian convertible bond universe, he said that while there are a number of large companies which are liquid and well-traded, there are also various smaller, non-rated companies. So looking at the creditworthiness of an individual issue is critical.
