The global convertible bond market, which languished in the doldrums since the great financial crisis of 2008/2009, has staged something of a comeback over the past 18 months or so. This whitepaper provides an overview of the exigencies of this instrument, the reasons for its resurgence and whether the trend will continue in light of the current inflationary environment.
The convertible bond is one of the more venerable instruments still in use in the global capital markets. The structure gave buyers the opportunity to participate in upside equity appreciation while offering a defensive fixed income return should shares fail to rally.
The basic structure is fairly straightforward and, in this respect, convertibles are largely unchanged. They pay buyers below-market fixed income returns while the attached warrants can be exchanged for equity at the holder’s option. They thus combine features of both equity and fixed income securities, and are often termed hybrid securities.
Convertibles incorporate a conversion price, which means the price at which the bond can be converted into stock. The conversion ratio refers to the number of shares that can be owned by the conversion of one bond. If the conversion ratio is 10:1, the one bond can be converted into 10 shares. The conversion ratio multiplied by the conversion price equals the bond’s face value.
These instruments offer advantages and disadvantages to both borrowers and buyers. The borrower can access capital at a lower coupon than would be the case if it were to issue plain vanilla debt. It is also essentially raising equity on a deferred basis. This means dilution of shareholders is postponed to a later stage. However, equity dilution is merely postponed – not avoided completely – and when the conversion options are exercised, the company might be subjected to share price volatility.
The buyer, as noted above, receives a fixed income coupon yet has the possibility of participating in equity appreciation. Essentially, the bond part of the security serves as a floor in the investment. Convertibles also offer a default hedge – in the event of bankruptcy, convertibles count above common equity. Yet the coupon is lower than if the borrower issued plain vanilla debt. And the rise in the price of the convertible will not match the rise in equity values in a bull market.
Contents
- Key drivers of the convertible bond market
- Are convertibles difficult to value?
- What is the right model to use for valuations
- The treatment of equity, rates and credit
- Advanced features of convertible
