Convertible Bonds
What are the 3 components of convertible bonds?
- Bond component: interest rate risk - Equity component: equity risk (long volatility) - Credit quality component credit risk.
Embedded Options
A convertible bond grants the investor the option to call the common stock of the issuer. Thus a convertible bond has an embedded call option on the common stock. However, most convertible bonds are callable. That is, there is a second embedded call option granting the issuer the right to retire the bond.
What does a convertibles bond value depend on?
A convertible bonds value depends on both interest rate changes and changes in the market price of the stock.
What is the breakeven on convertible bonds?
Break even (years) = conversion premium/ (convertible yield - stock yield) It is the number of years necessary for the stock investor to recover the conversion premium from the convertibles higher income, relative to an investment of an equivalent amount in the stock.
What are the motivations to issue convertible bonds?
Companies that are characterized by strong performing, high-visibility, sub-investment grade, and high-growth potential have a comparative advantage in the convertible market versus the fixed income market. Convertibles provide a way of selling common stock at a price above the existing market. They are employed as deferred common stock financing.
Convertible bonds offer a mean to control which ratio?
Convertible bonds offer a mean to control debt/equity ratio
What types of companies are typically convertible issuers?
Organizations that are characterized by strong performing, high visibility, sub-investment grade and high growth potential have a comparative advantage in the convertible market vs fixed income market.
What is the value of noncallable/nonputable bond?
Straight value + value of the call option on the stock
Valuing a convertible bond
The complication that arises is that one of the options, the call on common stock granted to the investor, depends on the future price of the common stock. However, the call on the bond granted to the issuer depends on the future interest rates. Thus, valuing a callable convertible bond requires including in one valuation model both future stock price movements and future interest rate movements.
What can the owner of a convertible bond do?
The owner of a convertible bond can exchange the bond for the common shares of the issuer.
What is the market conversion price of convertible security?
The price that an investor pays for the common stock if the convertible bond is purchased and then converted into stock.
What does a convertibles bond value include?
The value of a convertible bond includes the value of a straight bond plus an option giving the bond holder the right to buy the common stock of the issuer. Hence, interest rates affect the bond value and the underlying stock price affects the option value.