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Are Convertible Bonds the Best of Both Worlds?

Convertible bonds possess positive traits of both debt and equity, but they come with their own perils.

Phillip Yoo, 09/08/2017

What Is a Convertible Bond?
Like a regular bond, a convertible bond pays coupons, but this security gives investors an option to convert the debt into equity if the issuing company’s share price rises above a prescribed price. These hybrid securities are senior to equityholders during bankruptcy proceedings but usually subordinate to traditional bonds.

Convertible bonds have different return patterns depending on how the underlying common stock has performed since the issuance. If a convertible bond's corresponding stock price is below the conversion price, it is valued like a straight bond with an out-of-the-money call option attached. As the stock price reaches or surpasses the bond's conversion price, this instrument will begin to trade in line with the stock, allowing the investors to participate in the stock’s upswing.

Convertible bonds can be appealing because they offer much of the upside potential of stocks while limiting downside risk, as they offer regular bondlike cash flows before conversion.

Why Do Companies Issue Convertible Bonds?
Most convertible bond issuers are rated below-investment-grade. Raising capital through straight bonds may prove too costly for these firms, as they would have to offer high interest rates to entice investors to accept their credit risk. Alternatively, these firms could issue equity, which would lessen the burden on the issuer’s cash flow. However, doing so would dilute the ownership of current shareholders, and the market often reacts negatively to new share issuances. The primary reason for this is the adverse selection phenomenon. Equity investors conclude that, on average, only firms with a negative outlook would be willing to issue new shares and court new shareholders. While markets may react negatively to issuance of convertible bonds, the magnitude of the reaction tends to be smaller than an equity offering.

From the issuer’s perspective, it could secure equity capital at a relatively low issuance cost and avoid possible underpricing associated with seasoned equity offerings. Moreover, the firm benefits from knowing that the bonds will be converted into shares of common stock when the stock price is relatively high and may allow the firm to avoid repaying the bond’s principal.

Current State of the Convertibles Market
Traditionally, technology and healthcare firms have been the largest issuers of convertible debt. These companies often have limited assets to pledge as collateral and volatile cash flows, which may deter lenders from providing capital. But they have been able to attract investors looking to participate in stock price appreciation. Currently the convertibles market is dominated by technology companies. This is driven by growth-oriented companies such as Intel INTCLam Research LRCX, and Microchip Technology MCHP that have issued large amounts of convertible debt in the past few years. The surge in tech sector stock prices enabled these companies to tap the convertibles market at attractive terms. Convertible debt may also be more accessible than traditional debt financing for many high-tech firms because they often have volatile cash flows and limited fixed assets to pledge as collateral.

Investment Options
Convertibles funds can be a worthwhile choice for investors seeking the income of a bond while maintaining exposure to some upside potential of the underlying stock. There are many ways to get exposure to these securities.

The convertible bond market does not have as many active investors as the traditional investment-grade bond market because of the instrument’s complexity and smaller size of this market. It is difficult to accurately value a convertible bond. The call option on the underlying stock largely dictates the bond’s intrinsic value. However, like any long-run price forecast, the result is noisy. Furthermore, the volatility of the embedded call option is not directly observable, making it even harder to value the option using a traditional option pricing models. Also, because of the security’s hybrid nature, many traditional money managers do not have a natural place in their portfolios or their mandates. Consequently, these bonds are less liquid and costlier to trade.

Phillip Yoo is an analyst, passive strategies research, for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc.

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