Convertible Bonds

Abstract

Convertible bonds (CBs) represent an exciting but rather neglected section of the fixed income markets. This type of bond endows on its holder the right to purchase a defined quantity of shares at a defined price. This is achieved by returning the bond to the issuer at maturity, or in some cases earlier, and receiving in return the specified amount of equity. In the absence of a company’s demise or default there will be a floor value to the convertible bond (for example, its redemption value at maturity). On the other hand, should the price of the company’s shares rise the value of the bond will also rise but not necessarily in a perfectly correlated way. Expressed simply the bond has features of both fixed income and equity instruments and these features combined create a profile very much akin to that of a call option. This profile is identified in Figure 9.2 and will be examined in more detail in section 9.2. The hybrid equity/fixed income features of CBs make them attractive to a wide cross-section of market participants. At one end of the scale are risk-averse fixed income portfolio managers looking for returns linked to equity exposure whilst at the other end of the scale are risk-loving investors speculating that distressed paper will recover and, in the process of recovery, deliver a high return.