The Ideal Convertible Bond
To illustrate the relationship between the conversion value and the investment value of the convertible bond, we will disregard many of the realities of the marketplace. Figure 2-4 shows the relationship between movements in stock price (horizontal axis) and their effect on the convertible bond's market price (vertical axis). The arrow indicates the ideal price at which this convertible bond may be purchased. At this price, if the stock increases in value, the convertible bond value will increase at the same percentage. On the other hand, if the common stock were to decline in value, the convertible bond would be supported by its investment value and would maintain its market value. The price movement is indicated by the hatched area in Figure 2-5.
In this simplified example, when the convertible bond is priced at this ideal point, it is obviously a superior buy because it offers the same upside potential as the common stock with none of the downside risk. The real world, of course, will not allow investors such easy profit opportunities. In the financial marketplace there exists a trade off between the safety of the bond investment value and the opportunity of the conversion value. How much an investor is willing to pay for that trade off creates a premium above conversion value, as well as a premium above investment value, and it becomes the most complicated aspect of convertible investing. A measure of that value is the convertible security's conversion premium.
There are two basic scenarios for holding a convertible bond. First, if the company stock does well, the convertible increases in value—and can increase greatly in value as a bond without equity conversion. Many investors who are new to convertibles don't realize that it is not necessary to convert to the underlying common stock to realize a profit. The market price of a convertible varies with changes in the stock price, and the bond can be sold at any time. The increased value of the stock will be reflected in the market price of the convertible. Of course, the bondholder also has the option to convert the bond into stock, although that is not necessary. Conversion occurs only at the request of the holder.
Second, if the stock does not do well, the bondholder retains the bond and collects the coupon interest (which is almost always higher than the stock dividend), and par value is repaid at maturity. When the stock stays flat or falls, the bondholder still retains the investment value of the bond, which constitutes a floor value for the security; in an adverse equity market, the bond will not decline in price as much as the underlying stock because of this investment value. Furthermore, if interest rates rise, the bond principal is protected to some extent by the convertibility feature.
Although simple in principle, convertibles can be complex to manage. The dual nature of convertibles—i.e., they have characteristics of both bonds and stocks—is part of what makes them so difficult to analyze, and the evaluation process must take both parts into consideration. However, their dual nature is also what makes them so attractive as an investment.
The investor can calculate the value of both the bond and the equity portions of the convertible security, but that still doesn't give the entire story. The final piece of the evaluation might be the hardest: pricing the security itself. The investor must determine the bond's theoretical fair value or normal expected price, the value at which it is fairly valued in the marketplace, taking into consideration both its bond and its equity value, as well as its call terms, volatility, and the term structure of interest rates. This theoretical fair value is then compared to the market price to determine profit opportunity and market advantage. The convertible can be over or underpriced relative to the stock.
The investor must also evaluate how much the bond will rise or fall under different market scenarios. The risk/reward characteristics of the individual security depend on its value relative to its equity and bond values. This in turn determines the performance of both the security and the portfolio it is part of.
Since the concept of a convertible bond is easy for investors to grasp, some investors have tried to rely on simple rules of thumb in selecting convertibles. Examples of such rules are: "Buy converts only when the conversion premium is below 20 percent," or "Buy only when the time to break even is less than three years." However, the analysis of convertibles is not this simple. Strategies based on simplistic rules can only result in disappointing performance. The proper selection of convertibles requires careful analysis.
The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.
Past performance is no guarantee of future results.