Convertible bonds are essentially corporate bonds that could be converted by the bondholder into common stock or shares of the issuing company. These bonds give the bond holder the option to exchange the bond for a predetermined and mutually agreed amount of equity stock of the issuing company.
When the convertible bonds are first issued they are similar to the corporate bonds although they offer a slightly lower rate of interest. The apparent trade-off between risk and return is that such bonds allow the flexibility to be converted into the company�s common equity stock and benefit from a rise in the price of the same.
Therefore the interest accruals are lower in this case. However, if the stock performs poorly then the conversion does not take place and the bond�s sub-par return (less than the yield of a non-convertible corporate bond) persists.
Also known as the conversion premium, the conversion ratio determines the number of shares that could be converted from each bond and it is specified in the bond in addition to other provisions.
For instance a conversion ratio of 25:1 means that one convertible corporate bond can be exchanged for 25 equity shares of the company�s stock. Alternately a 40% premium could mean that the investor would have to pay the price of the equity stock during issuance in addition to 50 % of the value of the stock.
Convertible bonds incorporate the features of both bonds and stocks wherein the factors affecting their price has to be considered since these factors add up to the events in the sphere of interest-rates that impact bond prices and the market for the equity stock that impact the price of the stock. Again, convertible bonds can be called by the issuing company at a price that covers the company from any kind of turbulence in the stock market affecting prices in general. Therefore, while pricing convertible bonds it is very important that the above factors are considered.
Normally, convertible bonds closely follow the price of the actual stock but during times of market volatility the prices may go down affecting the bond yield. However, during such crises, bond investors normally get the par value at the time of the bond’s maturity.
A study on technology convertible bonds in 1995 by Merrill Lynch revealed that convertible bonds gave an average of around 70% of upside potential of the actual stock, and provided substantially higher levels of protection on the downside risks. This was evident from the smaller losses in the price of convertibles compared to that of equity stock.
Last Updated on : 10th July 2013