The convertible bond's investment premium is the difference between the convertible's market price and its investment value, expressed as a percentage.
An important measure of the basic value of the convertible is its premium over investment value. At this point, we determine the convertible's market value by calculating the difference between the convertible's market price and its investment value, expressed as a percentage. This value is important because it indicates the level of downside risk and can be monitored as market prices change. For example, in the case of a bond with a par value of $1,000 and an investment value of $798.70, the investment premium is ([1,000 - 798.70]/ 798.70), or 25.2 percent.
The higher the investment premium, the more sensitive the market price of the convertible is to a decline in the underlying common stock. A high market price relative to investment value is caused by increases in the value of the underlying stock such that the convertible's market value depends on the value of the stock. There is less downside protection because the stock would have to decrease in value by a significant amount before the market price of the convertible would approach the investment value and offer protection.
Similarly, when the investment premium is small, a small decrease in the value of the underlying stock would result in the market price reaching the investment value. At that time, the investment value floor serves as significant downside protection. Furthermore, when the investment premium is small, the convertible is more interest rate sensitive rather than equity sensitive and will typically be vulnerable to changes in market interest rates.
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.