Back in the 1800s railroad companies in the US needed to raise capital and so convertible bonds were issued to attract potential investors to the railway industry, writes Naeem Siddique, investment research manager at RSMR and Katie Poulson, client engagement and marketing manager at RSMR.
Convertible bonds offered investors the potential to earn interest alongside the option to convert bonds into equity.
In essence, an opportunity to benefit from any equity appreciation but with the security of interest and principal payments on their investment should the equity price fail to rise.
In short, investors were able to partake in upside returns while enjoying some protection on the downside.
What exactly are convertibles?
Essentially, they combine elements of stocks and bonds into a single investment.
They have the cash flow feature of bonds and appeal to investors because they can provide some protection against losses and may offer higher income than equities.
In a nutshell, convertibles can provide higher yields, greater downside protection, and seniority over ordinary shares and in the long-term, these characteristics can result in improved risk-adjusted returns.
The debt element of a convertible is based on the coupon or interest payment and the claim to the capital lent. The equity feature is based on a warrant or a call option and allows the investor to convert their holding into equity at a predefined ratio.
The pricing of convertible bonds depends on various factors, including the underlying stock price, conversion premium, interest rates, credit quality, and market volatility. The bond side of the equation is sensitive to credit spreads and interest rate movements and the equity element is impacted by the change in price of the underlying equity and volatility in equity markets.
What are the benefits for issuers?
Companies typically issue convertible bonds to raise capital and they are often issued by companies in a growth phase that have high growth potential.
They can allow businesses to borrow at lower interest rates than a traditional bond, without immediately diluting existing shareholders’ stakes through the sale of new stock. The amount of new stock to be issued is determined at the outset and the conversion ratio – the number of shares a bond can be converted into – is known to the investor at the time of purchase.
Investors are compensated for the lower coupon with the option to participate in any equity appreciation of the company.
The issuance of stock is basically done at a premium to the prevailing share price.
What’s so great about convertibles?
Just like other listed instruments, convertible bonds can be traded, giving exposure to a company but with some downside protection in place due to the bond structure element. Convertibles are sensitive to the underlying equity price so they can trade in different forms.
Convertibles that have a low sensitivity to the underlying equity price, generally below 30%, behave more like a bond because the equity option is ‘out of the money’ so it wouldn’t be favourable to convert the bond into equity. The convertibles pricing would be based on the coupon and investors could treat it as a bond.
The coupon payment is fixed but can be attractive relative to the equities’ dividend yield and the conversion premium or the option can be more balanced meaning that the convertible bond trades proportionately to the change in the underlying equity.
What about convertibles with greater sensitivity?
This area offers portfolio managers a good level of equity sensitivity and convertibles with a sensitivity of 80% or more would behave very closely to the underlying equity.
Are there any cons when it comes to convertibles?
When a stock declines, the associated convertible bond can decline less, because it’s protected by its value as a fixed-income instrument, but convertibles can still decline in value more than stocks due to their liquidity risk.
How are convertibles used in portfolios?
Convertibles can be a research-intensive asset class so portfolio managers must take a view on the fundamentals of a company, where the share price is trading, and consider whether this is fully reflective of the company’s’ fundamentals.
There is also a focus on the credit quality as the investor is lending to the company Most portfolio managers will take a view on convertibles that offer a balanced option meaning they are seeking to gain an equity-like exposure to a company and looking to benefit from the appreciation in that underlying equity.
Convertibles do tend to be more highly correlated with equities and high yield bonds but offer low correlation to investment grade bonds.
Since convertibles do not move in perfect unison with stocks and bonds, their addition to a portfolio can provide a divergent element, dampening the overall volatility, and potentially leading to better risk adjusted returns for an investor.
This article was written for International Adviser by Naeem Siddique, investment research manager at RSMR and Katie Poulson, client engagement and marketing manager at RSMR.
