Convertible bonds can be turned into stock, subject to various restrictions. Like all bonds, they pay a coupon, or interest, rate and return their face value when they mature. Zero-coupon convertible bonds pay all interest at maturity. The distinctive feature of convertible bonds is their linkage to an underlying stock. If the stock price rises, it can propel the bond price higher. Convertible bonds are often used by sophisticated hedgers to offset positions in the underlying stock. For example, if you are positioned to profit from a lower stock price, the convertible bond will offset some of your losses if the stock price rises.
The basic -- or vanilla -- convertible bond is issued with a conversion price -- the price that the underlying stock must attain to make the conversion profitable. Convertibles are normally issued with conversion prices that are substantially higher than the underlying stock price. If the bond is converted, the investor’s unpaid accrued interest is forfeited. For this reason, investors often wait until qualifying for the next interest payment before converting the bond to stock.
Convertibles can be embedded with a put option, a call option, or both. A call option gives the issuer the right to forcibly redeem the bonds before maturity for a preset price. The call date is usually staggered several years after the issue date. Call options are not attractive to investors, who require extra yield above the yields on vanilla -- or basic -- convertibles. Put options give the investor the right to sell the bond back to the issuer for an agreed-on price. This creates a floor price under the bond, is attractive to investors and thus lowers the required yield on the bond. Many convertible bonds offer both options.
Companies issue mandatory convertible bonds with specified conversion dates. Investors must convert their bonds to the underlying stock no later than this date. These bonds usually have relatively short durations.
The special feature of an exchangeable bond is that the underlying stock and the bond are from different issuers. Exchangeable bonds can have all the other features of convertible bonds.
Known as "co-cos," these bonds must attain a price above the conversion price before they can be converted. The required price is usually some fixed percentage above the conversion price, and the stock must trade at the required price for a specified period before conversions are allowed.
Foreign Currency Convertible Bond
These convertibles are denominated in a currency other than the one used in the issuer’s country. For example, a convertible bond for a U.K. company might be denominated in U.S dollars rather than British pounds. This feature would make the bond more attractive to Americans, because interest payments would not be subject to fluctuations in the exchange rate that result in fewer dollars per pound.
- The Handbook of Convertible Bonds: Pricing, Strategies and Risk Management; Jan De Spiegeleer et al
- Convertible Arbitrage: Insights and Techniques for Successful Hedging; Nick P. Calamos
- Beating the Indexes: Investing in Convertible Bonds to Improve Performance and Reduce Risk; Bill Feingold
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