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

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Convertible and Exchangeable Bonds

INTRODUCTION

The owner of a standard convertible bond (also known as a ‘convert’ or a CB) has the right to convert the bond into a predetermined number of shares. The shares are those of the issuer of the bond. Often conversion can take place over most of the life of the bond. The number of shares it can be converted into is called the conversion ratio. The current value of those shares is called the parity or conversion value of the CB. Some CBs have been issued in which the conversion ratio is adjusted in defined circumstances.

A CB 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 CB is first issued the investors do not pay a premium to the issuer for the embedded option. Instead, they receive a lower coupon rate (interest rate) than they would on a standard or ‘straight’ bond from the same issuer, i.e. one without the conversion feature.

A close relative is the exchangeable bond. This is exchangeable for shares of a company other than the issuer of the bond. Another variant is the mandatorily convertible bond, which must be converted into shares in the future.

INVESTORS IN CONVERTIBLE BONDS

Buyers of CBs tend to fall into two main categories. The first consists of hedge funds and traders searching ...