So, what is a convertible bond?

The equity component consists of a call option – i.e. the right (but not the obligation) for the convertible holder to require the company to repay, through the issue of new shares at a given ‘strike’ price.

Convertibles are hybrid securities containing elements of debt and equity. They give the holder the right (but not the obligation) to convert the bond into a fixed number of new or existing (Treasury) ordinary shares:

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• The fixed income component provides a cash coupon and downside protection similar to a fixed income instrument

• The equity component provides upside potential, which reduces the coupon level payable relative to a regular bond

 

At maturity, or if an issuer calls the bond:

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• If the stock price is higher than conversion price, investors will convert

• If the stock price is lower than the conversion price, investors will not convert, and the bond will be redeemed at its principal amount

What factors determine a convertible bond pricing?

 

• Bond Value: The value of the underlying bond, which is a function of the issuer’s credit spread (i.e. credit risk), bond coupon, market interest rates, investor puts, and issuer calls.

• Equity Option Value: The time value of the embedded option to convert the principal of the bond into equity. Intrinsic value greater than zero only when the strike price is less than the current spot price, which is not the case at the time of issue of a convertible bond with a premium. Time value is a function of the time to maturity, volatility expectations, and the interest rate. Typically a Black-Scholes model would be used to calculate option value. Higher volatility expectations will increase the value of the option.

 

Other terminology:

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• Parity = Value of the Underlying shares / Principal on the Bonds.However if there are other adjustments to conversion terms during the issue’s life, including FX changes.

• Yield advantage = Yield of the Convertible bond minus Dividend of the Underlying shares