Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options

Chapter 17. Convertible and Exchangeable Bonds

INTRODUCTION

A convertible bond (also known as a convert or CB) is a bond that can be converted into a fixed number of (normally) ordinary shares, at the choice of the investor. The shares are those of the issuer of the bond. Often conversion can take place during the whole life of the bond with the exception of short periods. The number of shares it can be converted into is called the conversion ratio. The current value of those shares is known as the parity or conversion value of the CB.

An investor in a convertible has the right to return the bond to the issuer and receive shares according to the conversion ratio. The bond has embedded within it a call option on the underlying shares, which will increase in value if the share price performs well. The option is embedded in the sense that it cannot be split off and traded separately from the convertible bond. It can only be exercised through conversion. When a convertible bond is first issued the investors do not pay a premium to the issuer for the embedded option. Instead, they receive a lower coupon or interest rate on the CB than they would on a standard or straight bond from the same issuer, i.e. one without the conversion feature.

The first cousin of the convertible is the exchangeable bond. This is exchangeable for shares of a company other than the issuer of the bond. Issuers include companies that hold significant stakes in other firms (known as cross-shareholdings) who wish to ...