Convertible Bonds

Definition
Convertible securities are usually either convertible
bonds or convertible preferred shares which are most
often exchangeable into the common stock of the
company issuing the convertible security
Being debt or preferred instruments, they have an
advantage to the common stock in case of distress or
bankruptcy
Convertible bonds offer the investor the safety of a
fixed income instrument coupled with participation in
the upside of the equity markets
Essentially, convertible bonds are bonds that, at the
holder's option, are convertible into a specified number
of shares

Convertible Bonds
Uses
For the issuer
Issuing convertible bonds enables a firm to obtain
better financial conditions
Coupon rate of such a bond is always lower to that of
a bullet bond with the same characteristics in terms
of maturity and coupon frequency
This comes directly from the conversion advantage
which is attached to this product
Besides the exchange of bonds for shares diminishes
the liabilities of the firm issuer and increases in the
same time its equity so that its debt capacity is
improved

 For the convertible bondholder

The convertible bond is a defensive security,
very sensitive to a rise in the share price and
protective when the share price decreases
If the share price increases, the convertible
price will also increase
When share price decreases, price of
convertible never gets below the bond floor,
i.e., the price of an otherwise identical bullet
bond with no conversion option

Convertible Bonds
Determinants of Convertible Bond Prices
Convertible bond is similar to a normal coupon bond plus a
call option on the underlying stock
With an important difference: the effective strike price of the
call option will vary with the price of the bond
Convertible securities are priced as a function of
The price of the underlying stock
Expected future volatility of equity returns
Risk free interest rates
Call provisions
Supply and demand for specific issues
Issue-specific corporate/Treasury yield spread
Expected volatility of interest rates and spreads
Thus, there is large room for relative mis-valuations

WHAT ARE THE BENEFITS AND DISADVANTAGES OF CONVERTIBLE BONDS

TO AN ISSUER AND AN INVESTOR ALIKE?
There are a number of benefits for issuers and investors in convertible
bonds. There are, of course, downsides for both parties to consider:

Issuer

Benefits

Disadvantages

The company receives up

front payment for ordinary
shares to be issued at a
later date, customarily at a
premium to their market
price. To the extent that a
company considers its
ordinary shares to be
undervalued at the time of
pricing of the bonds, the
issue of convertible bonds
may be an attractive
alternative to issuing
ordinary shares.
Investors demand a
lower interest rate on
convertible bonds than
plain vanilla bonds, given

The company is forward

selling its ordinary shares
through the equity call option,
which, if exercised, will lead to
dilution of existing
shareholders stakes in the
company this may be a
sensitive area from a
relationship perspective for
the company and put
downward pressure on the
companys share price. From a
legal perspective, the preemption right position of
existing shareholders will need
to be considered.
The ordinary shares of the
company may not perform

 If the companys ordinary

shares perform, the bonds
will convert into ordinary
shares and the company will
not need to repay its
borrowings. The company
is provided with access to a
broader investor base, as
convertible bond investors
consist of both hedge funds
and long-only investors

The hedging strategies of

certain investors may lead to
downward pressure on the
companys ordinary shares,
as some investors that
purchase the convertible
bonds may short the
ordinary shares to hedge
their respective positions

Benefits
Invest Irrespective of the
or
performance of the ordinary
shares of the company, the
bonds continue to provide a
fixed rate of income for
investors through the coupon,
and a protected return of
principal on their final maturity
date. If the company were to
become insolvent or be
liquidated, an investment in
convertible bonds would have
even rank with the companys
unsecured debt and rank
ahead of an investment in the
ordinary shares of the
company in insolvency
proceedings. The investor

Disadvantages
If the ordinary shares of
the company do not
perform, the investor will
have achieved a poor return
on its investment
(represented by the lower
coupon payable on
convertible bonds as against
the coupon payable on plain
vanilla bonds of a similar
credit) as at the final
maturity date. This
opportunity cost may be
partially offset by gains
made by shorting the
ordinary shares. The value
of convertible bonds can be
eroded by corporate actions