In our last post, we discussed preferred stocks and how they are a hybrid security with both bond-like an equity-like characteristics. In today’s post, I will go into a bit of detail on another type of hybrid security, convertible bonds.

What are Convertible Bonds?

On the most basic level, convertible bonds are corporate bonds that can be converted into shares of equity in the issuing company, with the conversion ratio and price set when the bonds are issued. Like bonds, they pay coupons and will return the face value upon maturity, assuming that they have not been converted to stock and that the company has not defaulted. Their value will also be affected by changing interest rates and credit spreads.

The equity component of a convertible bond is essentially a call option for the bondholder. For the simplest types of convertible bonds, if the stock price is above the conversion price at maturity, the investor would convert to stock, which could be sold immediately for cash. If the stock price has declined, the bondholder would receive the face value of the bond.

Most convertibles contain more complex features such as multiple conversion dates, mandatory conversion, caps and floors on prices, options for the issuer to call the bond or the holder to put. These characteristics complicate the valuation of these bonds, but by looking at the simplest type of convertible bond, we can better understand how they might perform in a rising rate environment.

Mitigating the Duration Risk

The prospect of converting a company’s bond into equity can provide investors with some relief in a rising rate environment. If rising rates signal an improving economy, then increasing stock prices can offset losses from the bond component as conversion becomes more valuable.

Many of the companies that issue convertible bonds tend to be small- and mid-caps, which have historically had growth that was on par or better than large-caps during other rising rate environments. For instance: 1

1. Between Dec 1998 and May 2000, the 10-year U.S. Treasury rate increased from 4.07% to 6.83%, a gain of 2.76%. During this period, large-caps increased by 17.4%, while mid-caps and small-caps both rose by 16.5%.
2. From March 2004 to Sept 2006, 10-year U.S. Treasury rate increased from 1.05% to 5.34%, a gain of 4.29%. During this period, large-caps gained 23.6% while small-caps returned 31.9% and mid-caps returned 27.9%.
3. From Jan 2008 to Oct 2008 the BBB bond rate rose 4.1% from 6.1% to 10.2%. During this period, large-caps lost 28.4% while small-caps lost 21.9% and mid-caps lost 28.3%.

While we would expect the bond portion of the convertible to decline in value during these periods, we would expect the equity portion to offset a portion of these losses in the first two periods, as equity prices increased. In the third period, when credit spreads were widening and equity prices were declining, the convertible would not realize much benefit from the equity portion. In this specific period, an investor would have likely seen some improvement as credit spreads tightened over the next year, but we can only say that because we know that spreads did tighten and equities bounced back as we passed the bottom of the financial crisis.

The takeaway is that the future performance of convertibles will be highly dependent on the path of both rates and equity prices.

Accessing Convertible Bonds

As in our previous posts about higher yielding alternative assets, there is an ETF available for investors to access convertible bonds. The SPDR Barclays Convertible Securities ETF (CWB) currently has over $2.7B in assets, which represents 1% of the U.S. convertible bond market. 2 This ETF regularly rolls over the redeemed issues and invests in new issues, making it easy for investors to hold a diversified convertible bond portfolio without worrying about conversion. It also trades in sufficient volume to remediate liquidity issues that one would face actually buying the bonds.

Breaking Down the Bond

Perhaps the simplest way to understand the valuation of a convertible bond is to examine its parts: the bond and the call option. We can visualize the effect of interest rate changes using the bond and of stock price changes using the call option. Combining the two will yield a rough picture of the response of a convertible bond to changes in these two factors.

The chart below shows the familiar relationship between bond price and interest rates. To make this example as concrete as possible, I have used a five year bond that pays semiannual coupons at 5%. Assuming that rates are at 5%, this bond is priced at par, and the chart assumes parallel shifts in interest rates.

For the call option, we can use the Black-Scholes formula along with some parameters. In this case, we will use a five year time period again and assume a risk free rate of 50 bps and a 25% volatility with no dividends. With these parameters, the value of the call option is shown below for changing stock prices.

Now let’s make a basic convertible bond for Company XYZ, whose share price is currently at $70. They would like the conversion price to be $100, so for $1000 of bond face value, the conversion ratio will be 10:1. To structure the convertible, we combine our pricing methods for the corporate bond and the call option.

To set the price of the bond at par, we can reduce the coupon rate to 3.25%, which is a benefit to Company XYZ, who would normally have to pay 5% based on their current credit spreads. The trade-off for them is that a conversion to stock will dilute their equity for other shareholders. The chart below shows the sensitivity of the price of this convertible bond to changes in both interest rates and the stock price of Company XYZ.

On this chart we can visualize sample paths for interest rates and stock prices to see how the price of the convertible bond might change.

Point A is the bond issued at par with the share price at 70% of the conversion price. If rates increase by 1% while the stock price increases to

78% of the conversion price (Point B), the bonds would stay at par. If rates increase a further 3% while the stock price climbs to 90% of the conversion price, the price of the convertible would drop to about 95% of its original value.

This analysis assumes instantaneous changes and thus neglects time decay for the option to convert, changes in volatility, and any interest paid by the bond, but it provides a point of reference for how increasing stock prices can offset price declines in the bond. In this example, the bond alone would have decreased to about 84% of par without the equity piece of the convertible.

As was the case with the other alternative, income-generating assets we profiled in other posts (Bank loans. MLPs. buy-writes. put-writes , and preferreds ), convertible bonds have the potential to diversify more traditional income generating allocations. Since the inception of CWB, its correlation with AGG and DVY was -0.25, and 0.75, respectively. Like preferreds, convertibles also provide access to yield without being entirely exposed to duration or credit risk.

One goal of many of our strategies is to “protect and participate.” Convertible bonds are a good example of an asset class that has this goal already built in. As markets are climbing, they will reap the benefits of capital appreciation from conversions. As the market turns downward, the bond piece could partially offset equity losses with the coupon payments. Their hybrid nature can make them a good addition to an income portfolio, especially for investors searching for yield but wary of rising interest rates.

1 Large-caps are represented by the SPDR S&P 500 ETF SPY. Mid-caps are represented by the iShares Core S&P Mid-Cap ETF (IJH) and the Vanguard Mid-Cap Index Fund (VIMSX) prior to the inception of IJH. Small-caps are represented by the iShares S&P SmallCap 600 ETF (IJR) and the Vanguard Small-Cap Index Fund (NAESX) prior to the inception of IJR.

www.janney.com/File%20Library/Unassigned/WM-Convertible-Bonds.pdf

Note: Newfound utilizes the SPDR Barclays Converible Securities ETF (CWB) in the Newfound Multi-Asset Income strategy.  Newfound encourages investors to seek the advice of a financial advisor as the appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.

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