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Understanding Convertibles IES 016

This document discusses convertible bonds, which are hybrid securities that pay interest like bonds but can also offer stock appreciation potential through conversion to common shares. It explains what convertible bonds are, how their behavior can be more like stocks or bonds depending on price movements, and how they have historically performed relative to stocks and bonds while providing downside protection. The document also outlines risks of convertible bonds and how they can fit into investment portfolios.

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Arjun Ghose
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93 views2 pages

Understanding Convertibles IES 016

This document discusses convertible bonds, which are hybrid securities that pay interest like bonds but can also offer stock appreciation potential through conversion to common shares. It explains what convertible bonds are, how their behavior can be more like stocks or bonds depending on price movements, and how they have historically performed relative to stocks and bonds while providing downside protection. The document also outlines risks of convertible bonds and how they can fit into investment portfolios.

Uploaded by

Arjun Ghose
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Investor

Education
Series

Understanding Convertible Bonds

What investment pays interest and repays principal like a bond, but also can offer appreciation potential, like a stock?
The answer may be found in convertible bondshybrid securities that can combine the best of both worlds.
What are convertible bonds?
By denition, a convertible bond is a corporate bond that can be
exchanged by the holder into a predetermined number of shares of the
issuers common stock. Like other bonds, convertibles pay interest at a
xed coupon rate and can be redeemed at the face (or par value) of the
bond. They also uctuate with changes in interest rates and the credit
quality of the issuing company, just like other types of corporate bonds.
In return for the conversion feature, convertible bonds generally carry a
lower coupon rate than nonconvertible corporate bonds; however, the
interest rate usually offers a yield advantage over the common stock
dividend rate. When convertible bonds mature, they can be redeemed
at their face valueor at the market value of the underlying common
shareswhichever is higher.
The terms of the conversion feature, which are specied when
the bond is issued, can be expressed as a ratio or a price.
The conversion ratio is the number of common shares into
which a convertible bond can be exchanged.

Do convertible bonds tend to behave more like


stocks or bonds?
At any given point in time, the trading behavior of a convertible bond
can take on either stock or bond characteristics, depending upon
where it is trading in relation to the bonds conversion price.
As the chart (below) illustrates, the security becomes more stock-like
as the price of the common shares riseswhich means that its
participation in the stocks upside potential tends to increase.
As the underlying stock price falls, the convertible becomes more
bond-like. If the stock price slips below the conversion price, the
convertible trades just like a bond, effectively putting a price oor
under the investment. It is important to note that convertibles are
also subject to the same risk factors as stocks and bonds including
market, interest rate and default risks.

Participation Potential, Volatility Cushioning

The conversion price is equal to the face value of the bond


divided by the conversion ratio.
100

Convertible Price

Once a bond is issued, the amount by which its price exceeds the
conversion price is referred to as the conversion premium. The conversion value is equal to the number of shares represented in the conversion
ratio, multiplied by the common share price. The example below shows
how these terms might apply to an actual convertible bond issue.

Appreciation Potential of a Stock


Protects Like a Bond

EXAMPLE:

Stock Price
Bond Value
Convertible

A $1,000 bond with a conversion ratio of 40:1 would convert


into 40 shares of stock at a conversion price of $25.
If the stock is trading at $30, the conversion premium
would represent $5/share, or 20% .
The conversion value would be $1,200.

0
Stock Price

For illustrative purposes only. The chart is not meant to imply that the price of a stock
will consistently rise during any market environment or that a bond will remain stable.

us.allianzgi.com

Is there a limitation to the upside potential provided


through the conversion feature of a convertible bond?

How have convertible bonds performed


in rising interest rate environments?

Many companies issue convertible bonds with a call option that gives
them the right to repurchase the convertible bond from the holder at
a specied price (usually the par value of the bond). In effect, this call
option can limit the bonds upside potential from the appreciation
of the underlying common stock.

Convertible bonds have historically exhibited negative to low


correlations to interest-rate-sensitive Treasuries. As a result, they
have traditionally exhibited attractive prices in rising interest
rate environments.

If the bond is structured with a put option, the holder has the right
to sell the bond to the issuer on a specied date, usually at the par
value of the bond. For the bond holder, this type of feature can
limit risk should the stock price drop sharply.

As part of a long-term asset allocation strategy, convertibles


can enhance portfolio diversication, because they dont
tend to move in unison with either stocks or bonds.

Over the long term, how have convertibles


performed relative to stocks and bonds?
Historically, they have delivered attractive asymmetric returnsthat
is, they have participated in more of the underlying stocks upside
than its downside. Since 1988, convertibles have posted returns
that were similar to stocks but with reduced downside volatility.

Convertible bonds have a favorable risk/reward prole


relative to more traditional asset classes.
12%

Risk vs. Reward January 1988June 2013

Annualized Total Return (Reward)

Bonds
6%
4%
2%

4%

8%
12%
16%
Annualized Standard Deviation (Risk)

For xed-income investors, convertible bonds can add growth


potential to a portfolio of bonds. The ability to convert into
common shares could be especially attractive to xed-income
investors concerned about the erosive effects of rising interest
rates and inationary pressures.
Convertible bonds are subject to the risks of both stocks and bonds
and are not suitable for all investors. These bonds can uctuate in
value with the price changes of the companys underlying stock. If
interest rates rise, the value of the corresponding convertible bond
will fall. Many of the companies that issue convertible bonds are
below investment grade, which means the bonds can be more risky
than investment-grade issues. Convertible bonds are often issued
by smaller companies and may be more volatile than securities
issued by larger companies.

8%

0%
0%

For income-oriented equity investors, the coupon paid on


convertibles tends to be higher than the dividend yield of the
companys common shares. History suggests that these
securities may offer equity-like returns, with less volatility.

What are the risks of investing?

Stocks
Convertibles

10%

How do convertible bonds t into an


investment portfolio?

20%

Sources: BofA Merrill Lynch, FactSet


Monthly data as of 6/30/13.
Past performance is no guarantee of future results. The chart on this page is not
representative of any specic investments and is not indicative of the past or
future performance of a specic investment. It is not possible to invest directly in
an index. Unless otherwise noted, index returns reect the reinvestment of income
dividends and capital gains, if any, but do not reect fees, brokerage commissions
or other expenses of investing. For the chart on this page, stocks are represented by
the S&P 500 Index, convertibles are represented by the BofA ML All Convertibles All
Qualities Index and bonds are represented by the Barclays US Aggregate Index. See
below for index denitions.

How can I invest in convertible bonds?


Investors can buy individual convertible bonds. To do this many
investors turn to professional fund managers who seek to exploit
market inefciencies and identify mispriced securities, as well as
help manage downside risk. To determine what suits your individual
circumstances, consult your nancial advisor. Funds that invest in
convertibles may have to convert the securities before they would
otherwise, which may have an adverse effect on the Funds ability
to achieve its investment objective.

Investors should consider the investment objectives, risks, charges and expenses of any mutual fund carefully before investing. This and other information is contained
in the funds prospectus, which may be obtained by contacting your nancial advisor or by visiting us.allianzgi.com. Please read this prospectus carefully before you
invest or send money.
This material contains the current opinions of the author, which are subject to change without notice. Statements concerning nancial market trends are based on current
market conditions, which will uctuate. There is no guarantee that these investment strategies will work under all market conditions, and each investor should evaluate their
ability to invest for the long term, especially during periods of downturn in the market. Forecasts, estimates and certain other information contained herein are based upon
proprietary research. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.
Coupon rate is the interest rate stated on a bond when it is issued. Yield refers to the interest or dividends received from a security and is usually expressed annually as a
percentage based on the investments cost, its current market value or its face value.
The Standard & Poors 500 Composite Index (S&P 500) is an unmanaged index that is generally representative of the US stock market. The Barclays US Aggregate Index is composed
of securities from the Barclays Government/Credit Bond Index, Mortgage-Backed Securities Index and Asset-Backed Securities Index. It is generally considered to be representative
of the domestic, investment-grade, xed-rate, taxable bond market. The BofA Merrill Lynch All Convertible All Qualities Index represents convertible securities spanning all corporate
sectors and having a par amount outstanding of $25 million plus. Maturities must be at least one year. The coupon range must be equal to or greater than zero and all quality of
bonds are included. Preferred equity redemption stocks are not included nor are component bonds once they are converted into corporate stock.
Mutual funds are distributed by Allianz Global Investors Distributors LLC.
2013 Allianz Global Investors Distributors LLC
FL-025-0713 | AGI-2013-07-23-7420

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