Convertible bonds: a brief introduction

The debt feature, meanwhile, provides a degree of downside protection.

Convertible bonds are hybrid financial instruments that marry debt- and equity-like features. They resemble conventional bonds in that they pay a defined coupon and principal upon maturity, but they also possess an embedded option giving their holder the right to convert the bond into a set number of shares. This means the convertible displays some equity-like characteristics too, including participation in some of the appreciation of the issuing company’s equity price. The debt feature, meanwhile, provides a degree of downside protection.The behaviour of a convertible bond depends in particular on two factors, called ‘parity’ and the ‘bond floor’. Parity is the value the investor would receive if the convertible were converted into equities. This value increases proportionally to the increase in the underlying equity price. Convertible bonds closely follow this value so that the higher the equity price the more likely they are converted in equity. By contrast, when the value of the underlying share price falls substantially, it begins to converge to the bond floor. This is the lowest value to which a convertible bond theoretically can fall and is independent of the price of the underlying stock. It is the calculated value of the bond, without taking account of the conversion feature. Assuming stability in interest rates and in the credit rating, the investment value of a bond remains stable over a wide share price range.

Convexity

The conversion option thereby allows convertible bonds to be naturally convex. This means that a convertible bond within the balanced/convex area (see figure 1) bond will offer an asymmetrical payoff profile that gives investors a higher participation in the rise of the underlying equity price than in any downward movement.

Convertible bonds also offer exposure to volatility strategies alongside their bond and equity component. While convertible bonds do suffer during equity sell-offs, the drawdown tends to be lower than for pure equity indices such as the S&P 500. This is because the bond floor renders convertible bonds less sensitive to equity declines. Increasing volatility also helps convertible bonds outperform equities as the value of the embedded conversion option rises. Overall, convertible bonds are generally less affected by volatility spikes than pure equities.

Furthermore, although their bond component means interest-rate fluctuations have an impact on convertibles, price movements in the underlying stocks historically has helped soften the negative effect of rising interest rates. In general, the more a convertible’s price is determined by the value of its underlying equity (the larger the delta), the less its tendency to be influenced by changing interest rates. Overall, as can be seen in chart 1, convertible bonds have performed relatively well when rate hikes have damaged the performance of bonds.

Furthermore, analysis of convertible bond performance since 1998 suggests that the asset class tends to outperform corporate bonds and perform in line with equities over complete market cycles. Chart 2 shows the returns of convertibles against equities as well as investment-grade and high-yield corporate bonds in the US since 1998.

Convertible bonds could therefore provide meaningful convexity and diversification to a portfolio while increasing its risk-adjusted return potential.