Convertible Bonds

Convertible bonds can be transformed into equities. A fixed ratio is set at the bond’s issue, and the bond can be converted into the fixed amount of shares. Purchase gives you the option to convert, but cannot be forced to do so. This gives you a lot of control. If the share prices rise you can convert them and cash in by selling or holding during the climb. If the shares fail you can retain the safety of bond ownership, receiving required interest payments and principle repayment. This combination seems great, but there are a few issues.

Issue 1: Compensation

The first is the compensation. When equities perform well, you can still cash in on the upside. If they don’t, you can remain in bonds to protect yourself from potential downsides. With this much control being given to bond holders there is very little reason to offer high compensation rates. Convertible bonds have a lower yield than a non-convertible bond in exchange for the control they deliver.

Issue 2: Control

The second issue is the limitations of your control. You can only convert bonds into the fixed ratio of shares if the share price is above a specific value. This price is known as the “Conversion Price”. The conversion price is usually above the market price at issue. This means that you can only convert if the shares rise, and usually substantially. The actual value of conversion is based on the distance between the market price and the conversion price. As market price approaches conversion price the value of the option increases.

Issue 3: Issuer

The third issue is the issuer itself. The convertible bond is only useful if the issuer is good. If the issuer is a poor or undesirable equity investment, you would never use the conversion from bond to stocks to begin with. You’re trading yield for the ability to convert the bond into shares. But it’s only useful if they would actually like to hold stock in the bond’s issuer. You shouldn’t be losing yield for an option you are never going to use.

Issue 4: Call Provisions

The forth issue with convertible bonds is the potential call feature. Some convertible bonds are issued with call provisions. This adds elements of unpredictability. The bond issuer could call the bond after the call date while market price is inching towards conversion price. They could call the bond after an interest rate increase, when market price is nowhere near conversion price. They could call the bond after the call date, when market price is above conversion price but you would prefer to hold the bond rather than convert to shares. In this case, you would lose your bond income anyway, and then the possibility to convert to shares. While this occurred, you would have received reduced yield from the callable bond. Call provisions on convertible bonds force you to covert and favor the issuers by removing your bond income if you stay.

Issue 5: Asset Allocation

The fifth issue with convertible bonds relates to asset allocation within a portfolio. If your portfolio is targeted, convertible bonds may disrupt your configuration. A younger single person focused on growth may do 70% equities and 30% bonds. An older married person focus on preservation may do 55% bonds and 45% equities. If either person purchases convertible bonds as part of their allocation and uses them, the ratio of equities to bonds will change. The more convertible bonds they buy and utilize, the more drastic the change in asset allocation. You will have to scale down your equity holdings if you use convertible bonds.

All of these potential complications display a specific tendency found in investments. The more complex an investment is, the more likely the complexity favors the issuer. Very rarely does a complex instrument favor the investing party. A complex instrument that attempts to do multiple functions but favors its issuer is often worse than a simple issue which favors investors.

Conversion and Share Value

Typically, the generic recipe for converting between Convertible bonds and share depends on these price relations. If the market price is substantially above the conversion price, you can convert and sell the shares. If the conversion price is the same as the market price, you can convert and hold the shares, or continue to sit on the bond. If you think the shares will nosedive or if the prices are highly volatile, you would continue to hold the bond.

The relation between conversion and market price may be based on price, but this says nothing about the actual intrinsic value of the shares. If you are approaching the usage of convertible bonds from a value stance, your actual actions will be different. The relationship between market price and conversion price will determine if you can sell. The relationship of market price, intrinsic value, and firm analysis will determine if you should hold or sell the shares after a conversion. Note that all sales actions should only occur if you believe you will capture more investment returns by converting bonds and selling the equities versus holding the bonds. Converting bonds and selling only to capture significantly less returns than you would receive via holding the bonds is not recommended.

You would analyze the company first and determine if it’s a firm whose shares you want to hold. If the firm is unattractive, or the firm’s share prices are volatile, you would not convert the bond to own the shares. If the firm is stable and analysis indicates future improvements, you would use the various valuation models to determine intrinsic share values. Then you would decide if you want to convert based on the relation between market price, conversion price, and intrinsic value.

If the market price was greater than or equal to the conversion price and exceeded intrinsic value, the shares would be overvalued. You can convert the bond to shares and proceed to sell. Even if the firm’s analysis is attractive, it would probably be unwise to hold the shares due to their inflated value, which may decrease in market pricing in the future. If the firm was volatile it would be especially unwise to hold the shares, and you should either hold the bond or sell the shares after conversion.

If the market price exceeded or was equal to conversion price but was less than intrinsic value, the shares would be undervalued. If the firm is volatile or an unattractive equity investment, you should continue to hold onto the bonds. If your analysis indicates the firm is a solid investment and will continue to grow in value, you could convert to shares and hold them. Shares that are undervalued and trending upwards they can become a solid investment.

If the market price is equal to conversion price and equal to intrinsic value, your course of action depends on your analysis of the firm. The firm is actually at its intrinsic value, and if you believe the firm will increase its intrinsic value long term you would retain the shares to capture your growth.