Why convertible securities

This diagram illustrates an arbitrage opportunity in foreign currency exchange. Additional advantages for issuers include:. Convertible bonds are safer for the investor than preferred or common shares; they provide asset protection, because the value of the convertible bond will only fall to the value of the bond floor. At the same time, CBs can provide the possibility of high equity-like returns.

Also, CBs are usually less volatile than regular shares. A primary disadvantage of convertible bonds is their liquidity risk. In theory, when a stock declines, the associated convertible bond will decline less, because it is protected by its value as a fixed-income instrument.

However, CBs can decline in value more than stocks due to their liquidity risk. Convertible securities also bring with them the risk of diluting control of the company and forced conversion, which occurs when the price of the stock is higher than the amount it would be if the bond were redeemed.

This feature caps the capital appreciation potential of a convertible bond. Privacy Policy. Skip to main content. Alternatively, there are many investment firms that offer mutual funds and exchange-traded funds ETFs that invest in convertible bonds.

There are options that suit almost any investor. However, bear in mind that these funds tend to be correlated with stock market performance and may resemble equity funds, albeit with higher dividend potential. Buying convertible bonds can be a complex affair. However, if you have strong convictions about particular companies, a convertible bond can let you pursue upside potential, albeit on a limited basis, while protecting yourself on the downside.

As always, speak to a financial advisor to learn more about how convertible bonds can fit into your investment portfolio. Rebecca Baldridge, CFA, is an investment professional and financial writer with over twenty years of experience in the financial services industry. She is a founding partner in Quartet Communications, a financial communications and content creation firm.

With two decades of business and finance journalism experience, Ben has covered breaking market news, written on equity markets for Investopedia, and edited personal finance content for Bankrate and LendingTree. Select Region. United States. United Kingdom. Rebecca Baldridge, Benjamin Curry. Contributor, Editor. Editorial Note: Forbes Advisor may earn a commission on sales made from partner links on this page, but that doesn't affect our editors' opinions or evaluations.

How Do Convertible Bonds Work? Convertible Bond vs Preferred Stock Convertible bonds are hybrid securities, meaning that they offer some of the characteristics of both fixed income and equity investments. Advantages of Convertible Bonds Companies reduce interest expenses due to lower interest rates. Companies avoid dilutive share issues. Investors enjoy a guaranteed income stream.

Downside is limited because the investor can recoup their original investment when the bond matures. Convertible bonds can add value within a diversified portfolio by reducing risk while maintaining expected return. Convertibles offer greater potential for appreciation than ordinary corporate bonds and the investor can convert to benefit from stock price gains. In a fixed income portfolio, convertibles can enhance returns through exposure to equity-driven price increases and reduce impact of rising interest rates.

In an equity portfolio, convertible bonds can help reduce downside risk without foregoing all upside potential. Pre-conversion, investors have some protection against default since bondholders are paid before stockholders. Disadvantages of Convertible Bonds Convertible bonds are callable, meaning that the issuer can force investors to convert. A bond may be issued with a specified call date or the company may call the bond and force conversion if the stock price rises beyond a particular point.

Therefore, the upside potential of the investment may be limited. Convertible bonds are highly correlated to equity markets, meaning their values may be more associated with movements in the stock market than other types of bonds. Convertibles are sensitive to rising interest rates, although to a lesser degree than plain old corporate bonds. Convertible bondholders are paid a lower coupon rate than corporate bondholders. In the s, we saw an increase in contingent convertible bonds, particularly within the European financial sector.

Banks issue cocos to address regulatory requirements for capital reserves. However, should the issuer come under financial distress, this newer breed of coco converts into equity or may even be completely wiped out. As a result, this newer breed of coco lacks the risk mitigation associated with a traditional convertible security. Securities with variable conversion ratios represent another innovation in the convertible market. A corporation will issue a convertible and pair it with additional warrants with the same strike price as the conversion price.

These extra warrants allow the corporation to issue the bond at a higher premium. We are also encouraged by trends in emerging markets, particularly emerging Asia and believe emerging markets will play an increasingly important role in the evolution of the global convertible market. In Section 6, we discuss the composition of the global convertible market at greater length. The convertible bond has three main parts: its value as a straight bond, called the investment value; its value as a stock, called the conversion value; and the theoretical fair value.

The investor must dissect the convertible security to understand the valuation process. The three factors are interdependent, and each must be considered for a proper valuation of a convertible security.

In this section, we begin the process of evaluating convertibles by dissecting the convertible bond into its various parts. This is the fixed-income component of the convertible. Conceptually speaking, it is the value of the bond without the conversion feature. It is calculated by determining what the value of the bond would be if it were not convertible, according to standard fixed-income analysis—company fundamentals, type of bond collateral or debenture , coupon and maturity date, sinking fund requirements, call features and yield to maturity.

The market value of a straight bond fluctuates with any changes in these factors. However, since the investment value of a convertible bond is embedded and is a component of the total market value of the convertible, changes in fixed-income determinants may not directly affect its market price. Figure 4. With the convertible value shown on the vertical axis and the stock price shown on the horizontal axis, the effect of changes in the variables is easily determined.

The investment value of a bond remains stable over a wide range of stock prices, if we assume stable interest rates for the sake of simplicity. The financial stability of the company and most of the other bond quality factors change slowly, if at all. Since investment value, therefore, remains constant over relatively short periods of time, it appears as a horizontal line on the graph.

The bond value is not affected by increases in the value of the common stock, although the market price of the convertible will be affected. In situations of deteriorating creditworthiness, the stock price begins to sink to zero. The obvious probable cause for this is a not-so-normal deterioration of company financial fundamentals, which causes the expected recovery of the full principal to come into question.

As shown in Figure 4. The decline of a particular stock due to overall negative market sentiment should not influence the investment value especially in the short run. The investment value will continue to provide an investment floor below the convertible market price, and the convertible bond should not fall below its investment value as long as the creditworthiness of the issuer remains unchanged.

This provides the essential safety element in convertible bonds. Furthermore, the convertible feature should ensure that convertible securities will always be more valuable than income-equivalent nonconvertible bonds. However, there are a number of factors that do influence the investment value of a convertible security.

In fact, deterioration of company fundamentals should cause a ratings downgrade. A stock decline caused by such factors will also cause the investment value to decline, reflecting the possibility that the company may not be able to pay the coupon or principal of the bond. In the ultimate case, both the value of the firm and the bond investment value would approach zero. Studies have shown that dramatic changes in the fundamentals of a company will have an immediate effect on bond investment value.

Investors who ignore these fundamentals in evaluating convertibles will be at a distinct disadvantage in the marketplace. Rating agencies may assist in this effort, but may not always be timely enough.

The investment value does fluctuate over the longer term, and it must increase to par value by the time the bond matures, regardless of how the common stock is changing. Of course, interest rates affect the investment value of convertibles like they affect the value of straight bonds.

As interest rates increase, the investment value will decline; as interest rates decrease, the investment value will rise. The investment value fluctuates in tandem with the price of straight corporate bonds of similar quality. However, due to the unique nature of convertibles, a change in the investment value of the convertible bond may not necessarily mean a change in the market price. The investment value may fluctuate, but the market price of the convertible bond remains relatively stable because changes in interest rates are just one of many factors that may be affecting the market price at any given moment.

A bond that is trading close to its investment value will be relatively more affected by changes in interest rates than one that is trading close to its conversion value and well above its investment value.

If the underlying stock is increasing in value as interest rates are rising, the convertible bond will be driven by its equity component rather than by its fixed-income component and will increase in value.

It is important to recognize that the investment value of a convertible bond at issuance is rarely near par. Arriving at a proper estimate of the investment floor is critically important in evaluating a convertible bond; it constitutes the minimum value below which the convertible bond should not fall, regardless of common stock fluctuations, and influences all other calculations in the mathematical analysis of convertibles.

An important measure of the basic value of the convertible is its premium over investment value. This value is important because it indicates the level of downside risk and can be monitored as market prices change. The higher the investment premium, the more sensitive the market price of the convertible is to a decline in the underlying common stock.

There is less potential downside protection because the stock would have to decrease in value by a significant amount before the market price of the convertible would approach the investment value. Similarly, when the investment premium is small, a small decrease in the value of the underlying stock would result in the market price reaching the investment value.

At that time, the investment value floor mitigates additional downside. Furthermore, when the investment premium is small, the convertible is more interest rate sensitive rather than equity sensitive and will typically be vulnerable to changes in market interest rates.

At the time of issue, the offering prospectus indicates the common stock price equivalent to the value of the bond at par. This price in turn determines the number of shares of stock into which each bond at par can be converted; this is the conversion ratio. Confusion often arises among investors because the conversion price is specified in the bond documents, but the conversion ratio is not; it must be calculated. The conversion price is meaningful only when the bond is at par, and it can be calculated by dividing the par value by the conversion price.

Investors often focus on the conversion price when they should be paying more attention to the conversion ratio. From the moment the bond is brought to market, it trades either above or below par value, depending on the market forces. Since the conversion rate remains the same whether the bond is at par or not, it is the more important number for investors. The conversion ratio determines the number of shares of common stock a convertible bondholder would receive if the bond were converted into stock.

The conversion ratio is set at the issuance of the security and is typically protected against dilution. It may well specify partial shares i. The conversion ratio is usually adjusted for stock splits and stock dividends. The initial conversion ratio in our example was 20 shares of stock per each convertible bond.

Prior to , convertible bondholders were rarely protected against normal cash dividends. Today, they are generally protected against normal cash dividends as well as special dividends and spin offs. We discuss this in greater length on page Conversion value represents the equity portion of the convertible bond. It is what the convertible bond would be worth if it were converted into common stock at current market prices.

In Figure 4. For any stock price, the conversion value is found by multiplying the given stock price times the stated number of common shares received per bond. As we have said previously, the number of shares each bond can be converted into is the conversion ratio and is set at the time the bond is issued. Like bond investment value, conversion value is a minimum value or price at which the security is expected to sell.

If the market price fell below the conversion value, specialists and market makers would quickly take advantage of the situation; the arbitrageur would buy the bond and simultaneously sell an equivalent number of shares of the underlying common stock.

The difference between these two values would be a risk-free profit to the arbitrageur. The equity value of a convertible bond was determined to be its conversion value.

Conversion premium can be calculated easily by simply taking the difference between the current market price of the convertible and the conversion value and expressing it as a percentage. Since the convertible bond is more secure than common stock and generally pays higher interest than the stock dividend, the convertible bond buyer is willing to pay a premium over the conversion value.

Market forces determine the amount of premium that a particular convertible may command in the market place. However, it should make sense that, as a convertible bond price increases above its investment value, its fixed-income attributes give way to equity characteristics, decreasing the conversion premium.

On the other hand, if the stock price declines, the convertible bond price approaches its fixed-income value and the conversion premium increases. Notice that as the stock increases in value, conversion premium gradually decreases until it becomes zero. At that point, the convertible market price and the conversion value are equal. As the common stock declines in value, the convertible gains conversion premium because it is approaching its investment value.

From another perspective, the market value of the convertible should always be higher than either the conversion value or the investment value. If we were to hypothesize a convertible with a market value that exactly equaled its investment value, the investment premium would have a value of zero and the convertible would be trading as if it were a straight non-convertible bond.

However, a convertible security has an implicit option, and as long as there is time remaining before the option expires—thereby providing the holder with equity potential—the option will have some value in itself. The convertible price curve can be either an estimate of how much conversion premium a particular convertible security would command at various stock prices or a historical depiction of how a convertible has actually traded as the common stock has fluctuated over time.

It is an extremely important consideration in evaluating convertible securities because it determines the upside potential versus the downside risk. Detailed mathematical formulae are needed to estimate the convertible price curve accurately. It is inadequate to rely on simple historical price relationships to properly analyze the fairness of the conversion premium level. To illustrate the relationship between the conversion value and the investment value of the convertible bond, we will disregard many of the realities of the marketplace.

The arrow indicates the ideal price at which this convertible bond may be purchased. On the other hand, if the common stock were to decline in value, the convertible bond would be supported by its investment value and would maintain its market value.

In this simplified example, when the convertible bond is priced at this ideal point, it is obviously a superior buy because it offers the same upside potential as the common stock with none of the downside risk.

The real world, of course, will not allow investors such easy profit opportunities. In the financial marketplace there exists a trade-off between the safety of the bond investment value and the opportunity of the conversion value. How much an investor is willing to pay for that trade-off creates a premium above conversion value, as well as a premium above investment value, and it becomes the most complicated aspect of convertible investing.

There are two basic scenarios for holding a convertible bond. First, if the company stock does well, the convertible increases in value—and can increase greatly in value as a bond without equity conversion. The market price of a convertible varies with changes in the stock price, and the bond can be sold at any time. The increased value of the stock will be reflected in the market price of the convertible.

Of course, the bondholder also has the option to convert the bond into stock, although that is not necessary. Conversion occurs only at the request of the holder. Second, if the stock does not do well, the bondholder retains the bond and collects the coupon interest which is almost always higher than the stock dividend , and par value is repaid at maturity.

When the stock stays flat or falls, the bondholder still retains the investment value of the bond, which constitutes a floor value for the security; theoretically, in an adverse equity market, the bond would not decline in price as much as the underlying stock because of this investment value.

Furthermore, if interest rates rise, the bond principal is protected to some extent by the convertibility feature. Although simple in principle, convertibles can be complex to manage. The dual nature of convertibles—that is, they have characteristics of both stocks and bonds—is part of what makes them so difficult to analyze, and the evaluation process must take both parts into consideration.

However, their dual nature is also what makes them so attractive as an investment. The final piece of the evaluation might be the hardest: pricing the security itself. This theoretical fair value is then compared to the market price to determine profit opportunity and market advantage. The convertible can be over- or underpriced relative to the stock.

As the stock declined in value, investment value also declined, because of credit deterioration. It indicates the importance of credit and fundamental analysis. The investor must also evaluate how much the bond will rise or fall under different market scenarios. This in turn determines the performance of both the security and the portfolio within which it is included. The proper selection of convertibles requires careful analysis, and simple rules of thumb are likely to result in disappointing performance.

For example, the yield curve of the s and the yield curve of would have wildly different ramifications for convertible valuation.

The call provision, which is standard in most bond indentures, is one of the most important features affecting the price of a convertible security. The issuing corporation retains the right to call the bond for redemption prior to final maturity. A call option gives the issuer a certain amount of control over the convertible issue.

The call terms typically indicate the circumstance under which the security can be called, the date, and the price. Call protection can be either hard or soft. Hard or absolute call protection protects the issue from being called for a certain period of time, no matter the circumstances. Soft or provisional call protection allows the issuer to call the security immediately under certain circumstances.

Convertibles can be issued with either or both types of call protection. When interest rates decline, issuers like to have the flexibility to be able to call an issue if they think they can refinance it more cheaply. This is true in general for all corporate bond issues.

Convertible issuers have another reason for wanting a call option: calling an issue forces bondholders to convert debt into equity, which can reduce debt levels and have a beneficial effect on the balance sheet. Call protection acts to increase the value of the warrant feature of the convertible bond since it allows a longer period of time for the stock to increase in value and for the bondholder to convert the bond to the stock at a profit. While waiting for the stock to increase in value, convertibles typically provide more income than the stock.

Without call protection, this income stream could be called away at any time, making the convertible much less attractive. Provisional call protection helps ensure that the investor will receive a certain level of capital gain before the issue can be called.

Before , most convertibles did not have call protection. However, the tide turned when a leading technology company issued a convertible in and called the issue before it paid a single interest payment. Institutional investors were furious. This case and others brought enough pressure on underwriters to demand call protection. Soft call protection was introduced in This variation provided that the bond could not be called unless the underlying stock increased to a certain level for 20 or 30 consecutive trading days.

A variation of soft call protection, the soft call with a make-whole provision, emerged in the late s and has evolved since. Such an issue becomes callable when the common stock meets a certain price, but the issuer pays a make-whole premium, such as the present value of the remaining coupons or some other compensation.

An antidilution clause protects the convertible security holder by allowing the conversion ratio to be raised or lowered in certain situations. Historically, convertibles typically have provided protection against stock splits by proportionately adjusting the conversion ratio for the amount of a stock dividend. If a convertible had a conversion ratio of 30 shares per bond prior to a two-for-one split, the conversion ratio would become 60 shares per bond after the split.

In cases of stock takeovers, convertible bond holders also have long received antidilution protection, albeit to varying degrees. Antidilution protections have strengthened in recent decades.

While convertible bondholders have long been protected against dilution resulting from stock splits and stock takeovers, it was not until relatively recently that convertible bondholders were protected from the dilutions resulting from cash dividends or cash takeovers.

These enhanced protections were driven largely by one company. In , a casino issued a cash dividend shortly after bringing a convertible to market, and the resulting dilution caused an uproar among the arbitrage investors who held the convertible. In the wake of this action, market participants basically forced underwriters to add protections in cases of cash dividends.

Dividend protection protects the bondholder in case the issuer raises or initiates a dividend after issuing the convertible. If this happens, the issuer increases the conversion ratio to offset the increase in the dividend. This adjustment then happens for any subsequent dividends at the higher rate.