A convertible bond's investment value is its value as a bond. This is the fixed income component of the convertible. (Keep in mind that investment value refers to this one aspect of convertible valuation and is not the same as the convertible security's market value.) Conceptually speaking, it is the value of the bond without the conversion feature. It is calculated by determining what the value of the bond would be if it were not convertible, according to standard fixed income analysis—company fundamentals, type of bond (collateral or debenture), coupon and maturity date, sinking fund requirements, call features, and yield to maturity. The market value of a straight bond fluctuates with any changes in these factors. However, since the investment value of a convertible bond is embedded and is a component of the total market value of the convertible, changes in fixed income determinants may not directly affect its market price.
The investment value of a bond remains stable over a wide range of stock prices if interest rates stay stable and drops only as the stock price approaches zero (meaning that the company is likely to be in financial distress). It is theoretically extremely unlikely for the value of a convertible to fall below its investment value, although in reality slight discounts to investment value do occur.
Figure 2-1 shows the relationship between the common stock price and market price of the bond investment value graphically as a horizontal line for normal price fluctuations. With the convertible value shown on the vertical axis and the stock price shown on the horizontal axis, the effect of changes in the variables is easily determined.
A Convertible's Investment Value
The investment value of a bond remains stable over a wide range of stock prices, if we assume stable interest rates for the sake of simplicity. The financial stability of the company and most of the other bond quality factors change slowly, if at all. Since investment value, therefore, remains constant over relatively short periods of time, it appears as a horizontal line on the graph. The bond investment value is not affected by increases in value of the common stock, although the market price of the convertible will be affected. In situations of deteriorating creditworthiness, the stock price begins to sink to zero. The obvious probable cause for this is a not so normal deterioration of company financial fundamentals, which causes the expected recovery of full principal to come into question. As shown in Figure 2-1, the value of the convertible bond must also approach its bankruptcy value.
The decline of a particular stock due to overall negative market sentiment should not influence the investment value, especially in the short run. The investment value will continue to provide an investment floor below the convertible market price, and the convertible bond should not fall below its investment value as long as the creditworthiness of the issuer remains unchanged. This provides the essential safety element in convertible bonds. Furthermore, the convertibility feature should ensure that convertible securities will always be more valuable than income equivalent nonconvertible bonds.
However, there are a number of factors that do influence the investment value of a convertible security. If the common stock declines due to company factors (unsystematic risk), poor earnings, or other causes, the bond's investment value will be influenced, similar to the way the value of a straight bond is influenced by a rating downgrade. In fact, deterioration of company fundamentals should cause a rating downgrade. A stock decline caused by such factors will also cause the investment value to decline, reflecting the possibility that the company may not be able to pay the coupon or principal of the bond. In the ultimate case, both the value of the firm and the bond investment value would approach zero. Studies have shown that dramatic changes in the fundamentals of a company will have an immediate effect on bond investment value. Investors who ignore these fundamentals in evaluating convertibles will be at a distinct disadvantage in the marketplace. Rating agencies assist with this effort, but may not always be timely enough.
In approaching the mathematical analysis of convertible securities, it's convenient to assume a stable investment value over the short term and that stock price fluctuation is due to general market sentiment. The investment value does fluctuate over the longer term, and it must increase to par value by the time the bond matures, regardless of how the common stock is changing.
Of course, changing interest rates affect the investment value of convertibles like they affect the value of straight bonds. As interest rates increase, the investment value will decline; as interest rates decrease, the investment value will rise. The investment value fluctuates in tandem with the price of straight corporate bonds of similar quality.
However, due to the unique nature of convertibles, a change in the investment value of the convertible bond may not necessarily mean a change in the market price. The investment value may fluctuate, but the market price of the convertible bond remains relatively stable because changes in interest rates are just among many factors that may be affecting the market price at any given moment. A bond that is trading close to its investment value will be relatively more affected by changes in interest rates than one that is trading close to its conversion value and well above its investment value. If the underlying stock is increasing in value as interest rates are rising, the convertible bond will be driven by its equity component rather than by its fixed income component and will increase in value.
It is important to recognize that the investment value of a convertible bond at issuance is rarely near par. The convertible bond is not discounted at its coupon rate, but rather must be discounted at a rate appropriate for the issuing company's nonconvertible debt. For example, if the company has issued a convertible with a 5 percent coupon and its nonconvertible debt is at 8 percent, then the investment value of the convertible will be discounted at 8 percent. On a 10 year bond, the investment value will be $798.70 for a bond with a $1,000 par value.
Arriving at a proper estimate of the investment floor is critically important in evaluating a convertible bond; it constitutes the minimum value below which the convertible bond should not fall, regardless of common stock fluctuations, and influences all other calculations in the mathematical analysis of convertibles. Because investment value is the hinge on which all other calculations depend, it's important to understand how the various factors affect it. Chapter 8 discusses this topic in detail.
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.
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