What is a convertible?

In simple terms a convertible security is a bond, preference share or loan stock that gives the holder the right to convert into the shares of the issuing company or, in some cases, another company. They are often described as ‘hybrid’ instruments, sharing the characteristics of both fixed interest and equity. Convertibles are similar to fixed interest instruments in that they pay a set rate of interest and generally have a fixed redemption date and, because they can be converted into equity they are sensitive to movements in the underlying share price. In a sense they provide the best of both worlds, the potential of equity appreciation plus downside protection.
Upside potential
On the other hand, convertibles also give investors the opportunity to participate in rising share prices. Since they can be converted into a set number of shares their value is directly linked to the price of those shares. When the share price rises the price of the convertible should also rise. Convertibles enable fixed interest investors to gain a link to the equity market.
Downside protection
Convertibles offer protection against price falls via yield support. When their price drops the yield provided by their fixed coupon payments and redemption will eventually become high enough to attract yield-oriented investors. Demand from these investors will then arrest the price fall. Convertibles are less risky than pure equity investments.

The Structure of convertibles

Coupon
The coupon is the rate of interest that the issuer pays to holders of the convertible. It is generally paid semi-annually in equal parts and is paid net of tax in the case of convertible preference shares and gross in the case of convertible bonds and loan stocks.
Redemption
Most convertible stocks have a fixed redemption date on which, if not previously converted into equity, the stock will be repaid. There are a few irredeemable convertibles that will pay their coupons in perpetuity or until conversion. Most convertibles are redeemed at the same price that they were issued (par) though some have premium redemption, meaning that they will be repaid at a higher price than they were issued at, increasing the redemption yield.
Conversion option
Each convertible stock carries the right to convert into a fixed number of shares, the conversion ratio, which is set at issue. The conversion ratio is derived by dividing the nominal amount of the convertible by the conversion price, which is fixed at a certain premium to the prevailing market price. The conversion ratio will be adjusted in the event of a reorganisation of the share capital, such as a rights issue. Some stocks only allow conversion once a year while others are continuous, with holders able to convert at any time from just after issue until redemption.
Call option
Some convertibles have an early redemption, or call, option whereby the issuer can redeem them before the final redemption date, often subject to certain conditions being met. This can have the effect of forcing the holder to convert into equity.
Put option
Convertibles may also have one or more put options, giving the holders the right to sell their convertibles back to the issuer at a fixed price on certain dates before final redemption. A put option acts as a floor under the convertible price, improving downside protection.
Indicated ranges at issue
While some convertibles are issued with their terms set from the outset, many are issued through a book building process. This involves the convertible being issued with a range of coupon and premium and potential buyers can indicate at what level they would buy the new stock. If there is a lot of demand the coupon will be set at the bottom of its range and the premium at the top.

Some definitions

Conversion value
A measure of intrinsic value; the value of the shares that would be received on conversion at the current share price. Calculated as R * S, where R is the conversion ratio and S is the current share price.
Conversion premium
The extra amount paid to own the convertible over its intrinsic value. Calculated as C / (R * S), where C is the convertible price. The premium is expressed as a percentage.
Yields
The running, or flat, yield on a convertible is the coupon expressed as a percentage of the convertible price. It is usual to subtract any accrued interest from the convertible price. Yields to redemption, call or put are calculated with compound interest formulae, equating the present value of the coupon payments and redemption to the convertible price.
Bond floor
The fixed interest value of a convertible is simply the value of the coupon payments and repayment, ignoring the conversion option. It is calculated using a discount rate appropriate to the issuer’s credit quality. If the convertible price were to fall towards this level it would attract buying interest from fixed interest investors, so supporting the price. For this reason it is called the bond floor and the convertible should not trade below that level unless the issuer’s credit quality deteriorates.

Caveat emptor - the prospectus

As with many financial instruments, the devil can be in the detail and investors considering the purchase of a convertible security should be aware of the small print, i.e. the prospectus or offer document of the stock. In the prospectus one will be able to find coupon rates, payment dates, conversion rates and dates and redemption details. There should also be explanations of how the convertible will be treated in the event of a takeover of the issuer, rights issues, special dividends and default. It is clearly better to own a convertible that has protection in the event of a takeover through an average premium clause and that has its terms adjusted if a large equity dividend is paid than one that doesn't. Reading the prospectus may be hard work but can often bring rewards.

Convertible performance relative to the underlying equity

Balanced convertible
When a convertible is first issued it is generally what is known as a 'balanced convertible', carrying both a yield and premium not far from average levels in the market as a whole. The price of such a convertible will move in the same direction as the underlying shares but at a lower rate. When the share price rises the convertible price will also rise but, as the conversion premium contracts, the rate of rise lags that of the equity. Conversely, when the share price falls, the yield rises, the premium expands and the convertible price falls at a slower rate. This is typical convertible behaviour; participating in equity price appreciation but benefiting from downside protection as share prices fall.
Strong equity performance - equity substitute
If the equity underlying a convertible enjoys a sustained rally the convertible price will also rise, responding to the increasing conversion value of the convertible. The rising price means a lower yield on the convertible and so investors will not be prepared to pay a premium, which will contract. Eventually the conversion premium will shrink to almost nothing and the convertible will simply move in line with the underlying share price. The convertible has become an equity substitute. The process of premium contraction can be accelerated if the equity yield rises towards that on the convertible, making conversion into equity the more valuable option.
Weak equity performance - bond type convertible
If the shares underlying a convertible suffer a period of weakness the convertible will also be dragged down, increasing its yield and the premium investors are prepared to pay. If the weakness continues the yield will rise to a level that attracts fixed interest investors and the convertible price will have reached yield support. The price of the convertible will then be relatively insulated from further moves in the share price and will instead respond to moves in interest rates or the issuer’s credit quality. These high yield, high premium, convertibles are known as bond-type convertibles. It is worth bearing in mind that, even though a convertible has become bond-like it still retains the conversion option and, should the share price recover, that option could become more valuable.

Valuation methods

Dividend discount model
This is the traditional method for valuing convertible securities and compares the income streams on the convertible and the underlying equity. The income received by the convertible holder over the life of the stock, from coupon payments and redemption, are discounted and compared to the present value of the expected dividends from the shares. This can be equated to the premium that the investor can afford to pay. Conversely, the actual premium equates to expected dividend growth. If the dividend growth implied by the convertible’s current price is higher than that anticipated by the investor then the convertible can be considered cheap. One drawback of this method is that it takes no account of the optionality of the convertible.
Option pricing models
These models treat convertibles as a bond plus a warrant (the conversion option). The value of the bond is the present value of the coupons and redemption, discounted at a credit rating appropriate to the issuer, while the warrant value is calculated using an option-pricing model, such as the Black & Scholes method or a Binomial tree. The theoretical value of the convertible is the sum of the two elements. The calculation depends on the volatility of the underlying equity, with a greater volatility making the option worth more, plus the rate of equity dividend growth and the risk-free interest rate. Further calculations can be performed in order to arrive at other qualities of the convertible, such as how much its price should change for a certain change in the underlying equity (delta) or volatility (gamma) or interest rate (rho). Hedge fund investors, who can generate profit from the difference in volatility between the convertible and the underlying equity, have used these models very profitably. Traditional convertible investors, looking for extra income, find them less useful.