ETFs that invest in convertible bonds are known as convertible bond ETFs. Convertible bonds are hybrid securities that have the characteristics of both equity and debt. Look into it more.
What is the purpose of a convertible bond?
- A convertible bond pays a fixed rate of interest but can be converted into a set number of common stock shares.
- The conversion of a bond to stock occurs at particular intervals during the bond’s life and is normally done at the bondholder’s option.
- A convertible bond is a hybrid asset that combines the benefits of a bond, such as interest payments, with the ability to buy the underlying stock.
What makes a convertible bond attractive to an investor?
The fundamental benefit of include convertible bonds in a fund or portfolio is that they provide equity-like returns while also providing bond-like protection. Convertibles can be thought of as a substitute for direct stock investment. Dissecting the graph: The fair value of a convertible is depicted by the convertible price line.
Convertible bonds allow you to lose money.
However, if the stock performs poorly, the investor may not be able to convert the security to shares and will be left with only the yield. However, unlike stocks, convertible bonds have a specified maturity date when investors would collect their investment, so they can only fall so far if the issuing business stays solvent. Convertible bonds, in this sense, have a lower risk than regular stocks.
Convertible bonds offer a higher potential for gain than corporate bonds, but they are also more exposed to losses if the issuer defaults (or fails to make its interest and principal payments on time). As a result, investors in individual convertible bonds should do thorough credit due diligence.
Are convertible bonds a good investment?
- Because the investor can reclaim their original investment when the bond expires, the risk is minimal.
- Convertible bonds can help diversify a portfolio by lowering risk while preserving projected returns.
- Convertibles provide a higher rate of return than regular corporate bonds, and the investor can convert to take advantage of stock price gains.
- Convertibles can improve returns in a fixed income portfolio by providing exposure to equity-driven price gains while also reducing the impact of rising interest rates.
- Convertible bonds can help decrease negative risk in a stock portfolio without sacrificing all upside potential.
- Bondholders are paid before stockholders, thus investors have some protection against default before the conversion.
What are the advantages of convertible bonds?
Convertible bondholders receive a fixed, limited income until the bond is converted, regardless of how profitable the company is. This is beneficial to the company since it allows common stockholders to get a larger portion of the operating income. If the company does well, it merely has to share operating income with the newly converted shareholders. Bondholders typically do not have the right to vote for directors; voting power is typically held by common stockholders.
When a corporation considers alternative financing options, if the existing management group is concerned about losing voting control of the company, selling convertible bonds will provide an advantage, if temporary, over financing using ordinary stock. Furthermore, because bond interest is a deductible expense for the issuing corporation, the federal government effectively pays 30% of the interest payments on debt for a company in the 30% tax band.
Are dividends paid on convertible bonds?
Dividend-protected convertible bonds were issued after 2002 in the majority of cases. The protection is such that all but a liquidation dividend payment can affect the value of the shares into which the bond is convertible.
What is the frequency of interest payments on convertible bonds?
Convertible bonds, like standard bonds, pay interest based on the coupon rate, usually semi-annually. If the bond was not converted into common stock before the maturity date, the bond’s par value, which is usually $1,000, is returned to the bondholder.
Although some convertible bonds can be redeemed or called early by the issuer, most convertible bonds have not had a call feature in the recent decade. Convertible bonds that can’t be called typically have a shorter maturity than those that can.
Convertible bonds differ from standard bonds in that the bondholder has the opportunity to swap the bond for a set number of common stock shares prior to the bond’s maturity date.
The conversion ratio is the number of common stock shares received by a bondholder in exchange for the par value of the bond. The conversion ratio and other requirements that must be met for the bond to be converted into stock are detailed in the prospectus for the bond issue.
When a corporation pays a cash or stock dividend, issues new stock shares, or splits its stock, most convertible bond offerings include a clause that boosts the conversion ratio.
The greater conversion ratio rewards convertible bondholders for corporate actions that increase the amount of stock shares issued or put downward pressure on the stock price.
Are interest rates on convertible bonds lower?
A convertible bond, as the name implies, allows the holder to convert or exchange it for a predetermined number of shares in the issuing business. They function similarly to ordinary corporate bonds once issued, albeit with a somewhat lower interest rate.
Companies give lower rates on convertibles since they can be converted into stock and hence profit from a gain in the price of the underlying stock. If the stock underperforms, there is no conversion, and the investor is stuck with the bond’s low returnbelow that of a non-convertible corporate bond. There is always a compromise between risk and reward.
Convertible bonds are they safe?
Because the convertible bond investor base is willing to accept non-standard structures, part of the appeal of convertible bonds as a financing vehicle is their structural flexibility.
However, for issuers attempting to find the optimal structure for them, or when evaluating multiple ideas and pricings, this same flexibility can be a source of difficulty.
Assume an issuer has a known credit curve, a known dividend yield (or projected dividend payments, and a known share price), and a known share price volatility. Let’s also assume that the shares are liquid and borrowable enough for any investor who wants to hedge to do so.
Common features
In that situation, there are six primary structural elements that influence convertible pricing, as well as a few secondary ones. The most frequent are:
- Time to maturity the larger the coupon, the longer the maturity (as the bond value typically falls, and the option value increases, but usually not as quickly).
- The higher the current coupon paid, the greater the bond component’s value.
- Conversion premium the smaller the option value, the greater the conversion price compared to the current share price.
- Investor put option(s) the value of the bond component increases if investors have the right to have their bond repaid early at par (without decreasing the option value).
- Issuer call option if the issuer has the power to call the bonds early (usually to compel conversion), the option value lowers the earlier the call can be exercised and the less stringent the share price test, the greater the impact.
- Dividend adjustment threshold – the higher the option value, the lower the dividend that the issuer can pay without compensating convertible investors with a drop in the conversion price.
Less common features
- Coupon vs. yield certain convertibles pay a lower coupon than the bonds’ return, with the difference paid as an above-par redemption price. This structure lowers the bond value (because future payments are often discounted at a greater rate due to an upward-sloping yield curve) and the option value (because future payments are typically discounted at a higher rate due to an upward-sloping yield curve) (as the stock price has to exceed the conversion price multiplied by the redemption price before an investor would choose to convert).
- Conversion price resets are a feature that is rarely found in Europe, but is more popular in Asia. If the share price does not perform well for a period of time, the conversion price will be cut to compensate investors. Including such a feature enhances the likelihood that the bonds will eventually be in the money, hence increasing the option value.
- Takeover protection clauses – While few convertible investors attach major variations in value to them upfront, some conditions offer investors the prospect of a windfall gain upon a future takeover, and hence may add value upfront (particularly if an issuer is seen as a takeover candidate).
- Most convertible bonds are senior, unsecured liabilities of the issuer, although some can be designed to be subordinated to other senior unsecured debt, or they might be unsecured when the issuer employs considerable amounts of secured debt (for example, in the real estate sector). Structured subordination can also be achieved by having the convertible’s maturity date follow that of other outstanding debt, or by implementing a negative pledge clause that allows significant amounts of secured debt to be added to the capital structure in the future, effectively subordinating the convertibles.
When constructing a new convertible, issuers should consider the impact of these points and choose which elements are most significant and how to trade off the less important aspects to obtain the desired result. It’s vital to keep in mind that some of these features have predetermined consequences (for example, a fixed coupon valid until the first call date), while others may incur charges (for example, a redemption premium, which may never be paid in cash). Finding the correct balance will increase the convertible’s chances of offering a positive experience for all parties during its life.
What makes convertible bonds so dangerous?
Because convertible bonds are fixed-income products, credit risk is the most important factor to consider. Convertibles and equities markets are also highly connected. When the value of the convertible portfolio’s underlying equities falls, the value of balanced convertible bond schemes suffers the most.