Convertible Corporate Bonds Explained

Convertible corporate bonds are a unique financial instrument in that they behave like both a bond and an equity at varying points in time. At the most basic level, they afford you the right to convert your bond position into a predetermined number of shares of common stock. This conversion is subject to a specific set of covenants that govern when and at what price the common equity shares are received. They also define the procedures that must be followed to effectuate the conversion. While a useful investment vehicle, these instruments possess subtleties that are important to understand before capital is committed.

The Mechanics of a Convertible Bond

A convertible bond is considered a hybrid security because it possesses characteristics of both a fixed-income instrument and an equity. While there is usually a lock-up period, before which no conversion is allowed, this type of security gives the holder the right to receive equity in lieu of his or her debt position. Essentially, a convertible bond is a fixed income obligation with an equity option attached. Typically, a convertible bond will carry a lower than average coupon rate because of the value you receive in the form of the option. You get the downside protection of the cash flows from the coupon payments and the upside equity participation through the option.

Due to the presence of the option, convertible bond prices are unique. Given both the par value of the bond and the number of converted shares that will be received, you can calculate the per-share value the bond places on the shares. When the common equity of the issuer is trading below this price, the convertible bonds trade similarly to traditional bonds. When the stock of the issuer is trading above the convert price, convertible bonds trade like equities.

Trading Convertible Bonds

The real peculiarities occur when the stock is trading around the convert price, either higher or lower. At these levels, you will observe these instruments exhibiting the qualities of each asset class. It is also at these levels that mis-pricing can occasionally occur and convertible bond arbitrage takes place. The arbitrageur will simultaneously buy convertible bonds (intending to sell them) and sell a corresponding amount of stock. The profits from these types of transaction are often as small as a few cents per share. These trades are done in massive size to make the few risks worthwhile. Because of these trades, cases of mis-pricing rarely persist.

Benefits and Drawbacks of Convertible Bonds

The benefit of owning a convertible bond is that you get some exposure to the positive performance of the issuer's stock while still receiving interest payments. The benefit to the issuer is that by granting the right of conversion, it is able to raise debt capital at a lower rate. If you have the benefit of the option, you are more willing to accept a lower interest rate. The drawback for the investor is that if the stock flounders, you will have received less interest. For the issuer, conversion dilutes the stock and can therefore hurt the stock price.

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