Like any bond, convertibles are issued with a stated coupon, maturity date and redemption value. But they also come with a conversion option that allows you to exchange them for a certain number of shares of the issuer’s stock at a stated price.
The main appeal of holding convertible bonds in a fund or portfolio is that they offer equity-like performance with bond-like protection. Convertibles can be seen as an alternative to direct equity exposure.
The bond component can provide:
- Modest current income
- Repayment of principal at maturity
- Downside protection
The equity component can provide:
- Potential for upside equity participation
How convertible bonds work
If the share price FALLS
- The convertible bond’s sensitivity to its underlying share price will decrease, but the convertible bond itself will not decline to the same extent as the equity.
- The level that will prevent the convertible bond from falling further down is known as the “bond floor,” which is essentially the par value of the bond (what the issuer has promised to repay the investor).
If the share price RISES
- The fair value of the convertible bond rises.
- As the share price approaches the conversion price, the convertible bond price will show an increasingly direct relationship with the movements of the share price.
- As the share price moves above the conversion price, the convertible bond price will begin to closely mirror the share price.
Similar to any other debt instrument or bond, a convertible bond involves the risk of the issuer not being able to repay the principal at maturity. On the left-hand side of the chart above, this credit risk is expressed as the steep fall of both the bond floor and bond price.
Convertible bonds can provide defensive equity exposure, especially in volatile markets
When overall market volatility increases, convertible bonds tend to do better because all of their associated defense mechanisms kick in. The fact that they have a bond floor and pay a coupon helps offset any price declines during market dips.Low correlation to interest rate fluctuations
In a rising rate environment, there is very low correlation of convertible bonds to interest rates. This is partially because convertible bonds can have lower duration relative to conventional bonds. Duration is a measure of the sensitivity of the price (the value of principal) of a fixed income investment to a change in interest rates.Yield can buffer downside
Some of the attractive features of convertible bonds are highlighted when the underlying stock price falls. This is because the current yield component of the bond may have the potential to offset some of the principal loss associated with a price decline of the underlying stock, depending on the amount of the coupon.Active managers have an advantage
The convertible bond market tends to be inefficiently priced due to complicated issuer call features that can impact bond prices. This presents a great opportunity for professional managers who have the ability to properly assess these securities.As with all investments, when it comes to convertible bonds, there is a risk/reward trade-off that must be weighed. Issuers usually offer convertible bonds at a lower coupon than they would otherwise offer regular bonds (ones without the “exchange option” of convertible bonds).
Most convertible bonds are also the issuer’s subordinated debt; meaning, other bondholders will be paid off first in the event of bankruptcy
It is important to understand that if the stock price does not appreciate, no conversion takes place and the investor will earn a yield below what they could have earned had they invested in a bond with no conversion feature or premium.
At their most basic, convertible bonds provide a sort of security blanket for investors who wish to participate in the growth of a particular company without all of the downside risk associated with equity investing. Holding convertible bonds also provides another way to diversify the fixed income component of a fund or portfolio.
Explore other opportunities in the bond market now. Or, if you are interested in learning more about convertible bonds, speak with your advisor.