Convertible bonds are hybrid financial instruments that combine traditional bonds with equities. This product gives the holder the option to exchange his bond for one or more shares during a so-called conversion period.
It offers both flexibility and complexity, varying by the diversity of the interest rate for example (can be fixed, revisable, variable, indexed, etc.).
A convertible bond can give its issuer the possibility of a partial or total early redemption or the possibility of forcing the conversion into shares before maturity (call option). The latter can also be left to the initiative of the holder (put option). The conditions of the conversion include the period and the conversion premium. All these elements make the convertible bond one of the most complex products to price.
In order to simplify the formulation of the latter, it can be said that it consists of a bond and a call option on shares.
Evolution of the stock price
Example : A 3% convertible bond sold for €10 giving the holder the right to convert it into a share with a price of €8 at issue. The investor has calculated the discounted value of the underlying bond (or bond floor) at 88% of the principal amount
The main users of convertible bonds are institutional investors and issuing companies. However, the use according to the two types is different. A company in need of capital to finance its operations may use convertible bonds if it believes that the current share price is undervalued, often including an amortization clause to its advantage. Once the share price has reached a satisfactory level (making the security “in the money”), it will force conversion into shares. The result will be a reduction in debt and a capital increase that will again provide the company with new financing opportunities.
In practice, however, convertible bonds are rarely used by listed companies compared to issues of shares or ordinary bonds.
In terms of institutional investors, these securities are mainly used for arbitrage purposes (hedge funds represent between 50 and 70% of demand). Convertible bonds provide protection against a fall in the share price and make it possible to take advantage of the rise in the share price by paying an often reasonable conversion premium.
Some alternative investment funds also use this type of product for delta neutral strategies by buying convertible bonds and short selling the underlying stock. The larger volumes than for traditional options and longer maturities allow arbitrage with volatility.