An Introduction to Interest Rate Sensitivity of Convertible Bonds

Abstract

A convertible bond is a hybrid instrument. It has both a fixed income and an equity component. The degree by which it resembles either a straight bond or the underlying equity is largely dependent on how much the derivative is ‘in or out of the money’. Convertible bonds reflect differing sensitivities to changes in prevailing interest rates depending on their equity or straight bond content. Before analysing the characteristic behaviour of convertible bonds, we will focus exclusively on the impact of changing interest rates on straight bonds, but even at this point it needs to be noted that one is ultimately considering convertible bonds (many of which have put and call provisions) as securities with ‘embedded options’. This chapter provides a convenient place to at least outline basic bond theory and relationships which are essential for convertible bond practitioners.