Assessing the value of convertible bonds

This article is part of
Alternative Investments - September 2014

In the investment universe one way to help safeguard an investment against market fluctuations is diversification. And one of the many possibilities open to investors and investment managers is convertible bonds.

Convertible bonds are a hybrid investment, sharing elements of both corporate bonds and company shares. It can be easy to become overwhelmed by all the details associated with convertible bonds and view them as a complicated investment, best to be avoided. They are not and a failure to understand the potential benefits could result in missing a good investment opportunity.

The initial purchase of a convertible bond is similar to traditional corporate bond investment. They both have a face value (the price paid for it), regular coupon or interest payments and maturity dates. The important difference between a corporate bond and a convertible bond is the option to convert the bond into shares of the issuing company.

Among the benefits of investing in convertible bonds is the asymmetry that it provides. Indeed, depending on the delta (the sensitivity to the equity market), the convertibles will benefit from the rise of the underlying equity on an up market. While it will not rise in exactly the same trajectory there will be a significant correlation to the underlying equity. However, on a down market, the convertible bond should not correct as much as the equity underlying as it is protected by the bond floor. Therefore by offering an upside correlated to the underlying equity and by protecting on the downside with the bond floor, the asymmetry offers the potential for a greater risk/return profile over the long term. Should a convertible bond have a delta lower than 25%, the convertible will behave more like a pure bond and should a convertible have a delta above than 60%, it would behave more like an equity. The best way to enjoy both worlds is a delta range from 30 to 60% where convexity can be maximised.

Whilst the downside is protected for as long as it remains a bond, the investor could lose theprotection of that bond if the price of the company’s stock rises to a level at which the issuing company can forcibly convert them into shares in order to limit the profit payable to the investor through the set, regular coupon bond payments. This does of course mean that you then hold higher value equity.

The key principle to keep in mind is that on the downside the convertible acts more like a bond offering protection against lowering share prices but on the upside it behaves more like equity offering potentially higher returns.

It is also important to note that the upward and downward path of the convertible bond price is smoother than the movements of the shares issued by the same company.

Another issue to consider when contemplating investing in convertible bonds is where to enter the market.

Investment grade convertible bonds are the best quality bonds, rated by agencies such as Moody’s and Standard & Poor’s, and issued by the financially strongest companies. But, they are also the most expensive owing to potentially strong returns and there can also be limited availability which will make them in higher demand. The cost should be weighed up by the potential benefits according to investor needs.