Convertible bond

In finance, a convertible bond or convertible note or convertible debt (or a convertible debenture if it has a maturity of greater than 10 years) is a type of bond that the holder can convert into a specified number of shares of common stock in the issuing company or cash of equal value. It is a hybrid security with debt- and equity-like features.[1] It originated in the mid-19th century, and was used by early speculators such as Jacob Little and Daniel Drew to counter market cornering.[2] Convertible bonds are most often issued by companies with a low credit rating and high growth potential.

To compensate for having additional value through the option to convert the bond to stock, a convertible bond typically has a coupon rate lower than that of similar, non-convertible debt. The investor receives the potential upside of conversion into equity while protecting downside with cash flow from the coupon payments and the return of principal upon maturity. These properties lead naturally to the idea of convertible arbitrage, where a long position in the convertible bond is balanced by a short position in the underlying equity.

From the issuer's perspective, the key benefit of raising money by selling convertible bonds is a reduced cash interest payment. The advantage for companies of issuing convertible bonds is that, if the bonds are converted to stocks, companies' debt vanishes. However, in exchange for the benefit of reduced interest payments, the value of shareholder's equity is reduced due to the stock dilution expected when bondholders convert their bonds into new shares.


Underwriters have been quite innovative and provided several variations of the initial convertible structure. Although no clear classification formally exists in the financial market it is possible to segment the convertible universe into the following sub-types:

Additional features

Any convertible bond structure, on top of its type, would bear a certain range of additional features as defined in its issuance prospectus:

Convertibles could bear other more technical features depending on the issuer needs:

Structure and terminology

Due to their relative complexity, convertible bond investors could refer to the following terms while describing convertible bonds:

Markets and Investor profiles

The global convertible bond market is relatively small, with about 400 bn USD (as of Jan 2013, excluding synthetics), as a comparison the straight corporate bond market would be about 14,000 bn USD. Among those 400 bn, about 320 bn USD are "Vanilla" convertible bonds, the largest sub-segment of the asset class.

Convertibles are not spread equally and some slight differences exist between the different regional markets:

Convertible bond investors get split into two broad categories: Hedged and Long-only investors.

The splits between those investors differ across the regions: In 2013, the American region was dominated by Hedged Investors (about 60%) while EMEA was dominated by Long-Only investors (about 70%). Globally the split is about balanced between the two categories.


See also: Bond option#Embedded options; Lattice model (finance)#Hybrid Securities.

In theory, the market price of a convertible debenture should never drop below its intrinsic value. The intrinsic value is simply the number of shares being converted at par value times the current market price of common shares.

The 3 main stages of convertible bond behaviour are:

From a valuation perspective, a convertible bond consists of two assets: a bond and a warrant. Valuing a convertible requires an assumption of

  1. the underlying stock volatility to value the option and
  2. the credit spread for the fixed income portion that takes into account the firm's credit profile and the ranking of the convertible within the capital structure.

Using the market price of the convertible, one can determine the implied volatility (using the assumed spread) or implied spread (using the assumed volatility).

This volatility/credit dichotomy is the standard practice for valuing convertibles. What makes convertibles so interesting is that, except in the case of exchangeables (see above), one cannot entirely separate the volatility from the credit. Higher volatility (a good thing) tends to accompany weaker credit (bad). In the case of exchangeables, the credit quality of the issuer may be decoupled from the volatility of the underlying shares. The true artists of convertibles and exchangeables are the people who know how to play this balancing act.

A simple method for calculating the value of a convertible involves calculating the present value of future interest and principal payments at the cost of debt and adds the present value of the warrant. However, this method ignores certain market realities including stochastic interest rates and credit spreads, and does not take into account popular convertible features such as issuer calls, investor puts, and conversion rate resets. The most popular models for valuing convertibles with these features are finite difference models as well as the more common binomial- and trinomial trees.

Since 1991-92, most market-makers in Europe have employed binomial models to evaluate convertibles. Models were available from INSEAD, Trend Data of Canada, Bloomberg LP and from home-developed models, amongst others. These models needed an input of credit spread, volatility for pricing (historic volatility often used), and the risk-free rate of return. The binomial calculation assumes there is a bell-shaped probability distribution to future share prices, and the higher the volatility, the flatter is the bell-shape. Where there are issuer calls and investor puts, these will affect the expected residual period of optionality, at different share price levels. The binomial value is a weighted expected value, (1) taking readings from all the different nodes of a lattice expanding out from current prices and (2) taking account of varying periods of expected residual optionality at different share price levels. See Lattice model (finance)#Hybrid Securities. The three biggest areas of subjectivity are (1) the rate of volatility used, for volatility is not constant, and (2) whether or not to incorporate into the model a cost of stock borrow, for hedge funds and market-makers. The third important factor is (3) the dividend status of the equity delivered, if the bond is called, as the issuer may time the calling of the bond to minimise the dividend cost to the issuer.

Uses for investors

In consequence, since we get , which implies that the variation of C is less than the variation of S, which can be interpreted as less volatility.

Redemption options/strategies

Uses for issuers

The pro-forma fully diluted earnings per share shows none of the extra cost of servicing the convertible up to the conversion day irrespective of whether the coupon was 10pct or 15pct. The fully diluted earnings per share is also calculated on a smaller number of shares than if equity was used as the takeover currency.
In some countries (such as Finland) convertibles of various structures may be treated as equity by the local accounting profession. In such circumstances, the accounting treatment may result in less pro-forma debt than if straight debt was used as takeover currency or to fund an acquisition. The perception was that gearing was less with a convertible than if straight debt was used instead. In the UK the predecessor to the International Accounting Standards Board (IASB) put a stop to treating convertible preference shares as equity. Instead it has to be classified both as (1) preference capital and as (2) convertible as well.
Nevertheless, none of the (possibly substantial) preference dividend cost incurred when servicing a convertible preference share is visible in the pro-forma consolidated pretax profits statement.
The cosmetic benefits in (1) reported pro-forma diluted earnings per share, (2) debt gearing (for a while) and (3) pro-forma consolidated pre-tax profits (for convertible preference shares) led to UK convertible preference shares being the largest European class of convertibles in the early 1980s, until the tighter terms achievable on Euroconvertible bonds resulted in Euroconvertible new issues eclipsing domestic convertibles (including convertible preference shares) from the mid 1980s.

2010 U.S. Equity-Linked Underwriting League Table

Rank Underwriter Market Share (%) Amount ($m)
1 J.P. Morgan 21.0 $7,359.72
2 Bank of America Merrill Lynch 15.3 $5,369.23
3 Goldman Sachs & Co 12.5 $4,370.56
4 Morgan Stanley 8.8 $3,077.95
5 Deutsche Bank AG 7.8 $2,748.52
6 Citi 7.5 $2,614.43
7 Credit Suisse 6.9 $2,405.97
8 Barclays Capital 5.6 $1,969.22
9 UBS 4.5 $1,589.20
10 Jefferies Group Inc 4.3 $1,522.50

Source: Bloomberg

See also


  1. Scatizzi, Cara (February 2009). "Convertible Bonds". The AAII Journal. Retrieved 8 September 2015.
  2. Jerry W. Markham (2002). A Financial History of the United States: From Christopher Columbus to the Robber Barons. M. E. Sharpe. p. 161. ISBN 0-7656-0730-1.
  3. Hirst, Gary (June 21, 2013). "Cocos: Contingent Convertible Capital Notes and Insurance Reserves". Retrieved April 13, 2014.

External links

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