What You Should Know About Convertible Bonds

December 28, 2015 by

market bondsWhat is a convertible bond and what does it have to do with a rising rate environment? Matt Tucker explains.

Studiosmart / Shutterstock

Studiosmart / Shutterstock

As investors continue to seek yield in the current market environment, I thought now may be a good time to bring up an often overlooked asset class—the convertible bond.

WHAT IS A CONVERTIBLE BOND?

A convertible bond is a type of debt security issued by a company. Like other bonds, they promise to pay interest on a regular basis and have a stated maturity date when they return par. What makes these bonds “convertible” is that the holder of the bond has the right to convert it into shares of the company’s common stock. The bond holder will generally only convert if the stock prices rise to a level that makes it economically beneficial to do so. Because of this feature, the convertible bond will increase or decrease in value as the price of the company’s stock changes. The overall performance of convertible bonds tends to lie somewhere in between traditional stocks and bonds.

Relative to a traditional bond, convertible bonds generally have lower coupon payments. The holder of the convertible bond is willing to accept a lower coupon for the potential upside appreciation of the security. Relative to owning company stock directly, convertible bonds offer some protection. If the company’s underlying stock decreases in value, an investor can still hold onto the convertible bond and receive the bond’s par value at maturity, as long as the issuer does not default. In return for this protection, an investor will benefit less in a stock rally than if they had held the company’s stock directly.

Because of these features, convertible bonds offer some of the potential upside of holding equities, combined with some of the downside protection of owning bonds.

  • Stock Price Rises: The bond’s price tends to rise and the convertible bond will start trading more like the stock.
  • Stock Price Falls: The convertible bond acts more like a bond since the likelihood of converting to stock decreases.

To illustrate the comparison of a convertible bond’s price to its common stock price, we look at conversion parity, which is the value you would receive if converted to stocks today; the conversion premium, which is the amount the bond is trading above the conversion parity, or how much you would pay for the option to convert to stocks in the future; and delta, which measures the sensitivity of the convertible bond’s price to changes in the underlying stock price.

Mechanics of Convertible Bonds

HOW DO CONVERTIBLE BONDS BEHAVE IN DIFFERENT ENVIRONMENTS?

Typically in rising rate environment, stocks have historically outperformed traditional bonds.1 The Fed will generally raise interest rates to cool a growing economy and stocks usually continue to appreciate during this time. Convertible bond prices tend to correlate positively with the stock market.2 If stocks are going up in general, then convertible bonds are more likely to be converted.

For example, when the Fed raised rates from 1 percent to 5.25 percent from June 2004 to June 2006, traditional bonds returned only 2.9 percent. Convertible bonds outperformed traditional bonds by returning 6.1 percent. Converts outpaced bonds, but still trailed equities which returned 7.5 percent annualized.

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