Convertible Bonds

Also known as Convertible Loan Stock
These are issued by corporations and can be converted into a specified number of shares in the company at certain times during a bond's life
The terms of the conversion (basically the number of shares per bond and the time at which the exchange can be made) are specified in the bond's indenture.
Given that this option is valuable for investors these bonds pay a lower interest rate compared to normal bonds.


Bonds/Notes which can be converted for newly issued shares or bonds at pre-determined prices during specified periods of time.



The principal amount has to be repaid at a future date if not converted.
A security paying a fixed rate of interest which can be changed in the future for ordinary shares


Convertible bonds are bonds that can be converted later, either into a type of bond (for example convertible gilts) or into equity. The difference between the implied conversion price of the equity and the market price is called the premium. For example, the bond may confer the right after 3 years to convert $100 of bond into 50 shares. The conversion price is $2 per share; if the market price is $1.60 at the time, then the initial premium is 25%. If the conversion price remains above the market price, then the bond will redeem in the normal way


Why would you buy a convertible bond ?
The attraction to the investor is the mix of risk and return - the steady income we associate with a bond with the possible capital gain we associate with a share. For the issuer, the finance is cheaper as the interest rate will be less due to its attraction.


What is investors wish to convert, where do the shares come from - The issuer will have to create new shares. Suppose the bond is $500m. The issuer hopes that instead of having to find $500m to redeem the bond, they will issue $500m of new shares instead. The equity will obviously be diluted but it probably wont be by a large margin.


In Europe (not so much in the US) shareholders must give their approval for the issue of convertibles because any new shares issued for cash must be offered to the existing shareholders first.


Convertible bonds (CB) have features of both bonds and warrants.
They pay a stream of coupons with a final repayment of principle at maturity, but they can be converted into the underlying stock before expiry.
On conversion rights to future coupons are lost.


If the stock price is low then there is little incentive to convert the stock, the coupon stream is more valuable.
In this case the CB behaves like a bond.


If the stock price is high then conversion is likely and the CB responds to movements in the asset.
Because the CB can be converted into the asset, its value has to be at least the value of the asset
This makes CBs similar to American options; early exercise and conversion are mathemtically the same ??


Convertible Bond Arbitragers

They will take a particular view on the direction of the underlying credit quality of a particular convertible bond and will use a CDS to neutralise exposure. They may also use an IRS to hedge out the interest rate exposure coming from the fixed coupon and fixed redemption at maturity of the convertible bond.
They can also hedge out the risk of adverse equity price movements by selling short the shares that are underlying to each convertible bond. If the liquidity of the shares is restricted they may use derivatives on Equity-Indices to increase/decrease exposure (for example Asian equities during US trading hours) useful if you need a speedy execution.


Debenture Stock - probably secured on specific assets of the company
Convertible Loan Stock - almost certianly unsecured. It is not secured on the assets of the company and to this extent is a bit more risky than the debenture stock
Its most important feature is that it is convertible/
At some stage often from the outset it can be exchanged for odinary shares according to a pre-arranged formula.
This gives it some of the attributes of an ordinary share, though in legal and accounting terms it is a loan
Until it is converted it pays a fixed rate of interest.
Once it is converted into ordinary shares the shares are identical to the other shares in issue and receive the same dividend.


If the stock is not converted into shares during the conversion period, it may revert back to being a simple unsecured loan stock, paying the fixed rate of interest until maturity date.


Whether or not holders of the stock exercise the right to convert it will depend on how successful the company is.


The conversion terms were probably pitched originally at a level somewhat above the company's share price when they were issued (the conversion premium)
If the share price at the time had been 80p the terms of the loan might have stipulated that £1 nominal of the loan could be converted into one ordinary share
Five years later if the company share price had risen to 180p, there is clearly some value in the right to exchange £1 nominal for a share worth 180p
Because of this conversion value, the price of the convertible loan stock would have risen in the market.


In general a convertible loan stock rises in value to reflect the rise in value of ordinary shares.
On the other hand, it normally provides a higher and more secure yield than the ordinary shares, at least in the early yields until the dividend on the ordinary shares catches up.
The main advantage of the a convertible bond for the company is that the fixed interest rate it will pay out will probably be lower than that for an ordinary unsecured bond.
Investors will accept the lower interest rate because of the possibility of capital gains if the share price rises.
The convertible also represents a form of "deferred equity".
If the company had issued ordinary shares instead, its earnings and dividends would immediately be spread over a larger number of shares; the earnings would be diluted over the larger capital immediately.



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