Convertible bonds are corporate bonds with an embedded equity option and often with embedded (issuer) calls and/or (holder) puts. The bonds can be converted into equity at a pre-specified ratio, the conversion ratio; or alternatively, at a pre-specified price, the conversion price, which is at a premium to the underlying equity spot price at issuance. Convertibles have characteristics of both bonds and equities (or equity derivatives if held on a hedged basis), i.e. they are hybrids. Convertibles typically have a lower coupon and yield compared with a straight bond due to the embedded option value.

There are many options available to issuers when structuring their convertible bond issue to suit their financing needs best, including:

• “Plain vanilla” convertible (eg, five-year convertible, around 2-3% coupon, 20-40% conversion premium callable after two years and puttable after three).
• Exchangeable, issued by a different company to the underlying stock, very common in Europe for divestment/privatisation.
• Floating rate coupons.
• Perpetuals/deeply subordinated structures.
• Mandatory convertibles/exchangeables.

The features embedded in a convertible can greatly affect its valuation, some are advantageous to the issuer while others are beneficial to the bondholders. Prospectuses should be read carefully to fully understand all the bond’s features.

• Calls give the issuer the opportunity to redeem the bond, over a pre-specified period and under pre-specified conditions.
• Puts permit the bondholder to redeem the bond on pre-specified dates, usually at issue price or accreted value.
• Dividend protection: compensates bondholders for foregone stock dividends in excess of set thresholds.
• Takeover protection: compensates bondholders for loss of optionality/credit deterioration in a change of control event.

Similar to a call option, the value of a convertible bond resembles a convex profile, bounded by the bondfloor and parity (the value of the underlying shares).

• Payoff at maturity is the greater of parity and the redemption price.
• At any time prior to maturity, the convertible bond value is bounded below by parity and by the equivalent straight bond value, i.e. the ‘bond floor’.
• The convertible bond value approaches parity as the stock price rises because, in the limit, there is no time value, i.e. no ‘optionality’.
• The value of a corporate bond typically falls as the equity decreases towards zero due to the increased risk of default. In this event, bondholders compete with other creditors (on the basis of their relative ranking and subordination) to extract as much value as possible from the restructuring or liquidation: this is the ‘recovery value’.

Being a hybrid structure (i.e. a combination of bond and equity features) a convertible bond is sensitive to a range of variables:

• Delta: equity sensitivity = change in value of the convertible bond per unit change in parity.
• Gamma: equity sensitivity of delta = change in value of the convertible bond delta per unit change in parity.
• Vega: volatility sensitivity = change in value of the convertible bond per unit change in volatility.
• Rho: interest rate sensitivity = change in value of the convertible bond per unit change in the risk-free yield curve.

Companies choose to issue convertible/exchangeable bonds instead of straight bonds or equity, or at a certain time, for a variety of reasons, including:

• Reduced cost of capital versus straight equity or straight debt: Convertible bonds, however, enable the company to either sell (deferred) equity at a considerable premium if the holders convert or issue straight debt with a significantly reduced coupon/yield if the bonds are redeemed. Whether the bonds are converted or redeemed depends largely on the realised stock growth rate.
• Valuation/pricing: The market forces of supply and demand – both from investors and from banks that are competing for the deals – mean that convertible bonds may be priced on very favourable terms to the company.
• Market opportunity/timing: Companies may take advantage of a sharp rise in their equity to opportunistically issue a convertible on favourable terms to the issuer when their stock is attracting positive sentiment.
• New/broader investor groups: Convertible bonds attract additional investor groups, such as hedge funds, outright convertible funds and institutional trading desks.
• Capital structure/reporting benefits: As hybrid products, convertibles may be accounted for in various ways depending on accounting rules and on its terms and features.
• Tax advantages: Depending upon the jurisdiction of the holder and issuer, Convertibles may have the effect of reducing or deferring tax liabilities

A wide range of investors buys convertible securities for various reasons, as they have become an increasingly popular and better-understood asset class.

• Equity funds: downside protection and/or yield advantage.
• Fixed income and high yield investors: upside participation, credit exposure.
• Convertible funds: valuation and security-specific strategies.
• Hedge funds: leveraged option trading and hedging-based strategies.
• Risk-arbitrage/specialist funds: corporate activity and special situations.