Introduction to Fixed Income Analytics: Relative Value Analysis, Risk Measures, and Valuation, Second Edition

CHAPTER 10

Analysis of Convertible Bonds

Corporations must fund their operations by selling claims to the expected future cash flows they generate. The two basic claims issued are debt and equity. Debt claims are fixed by contract; equity claims are residual. Between these two endpoints, there exists a continuum of securities that possess features of both debt and equity. Among the most prominent of these hybrid securities is convertible bonds. A convertible bond is a combination of an option-free bond and the option to convert the bond into a given number of shares of the issuer’s common stock. Convertible bonds are typically callable and may be putable. Depending on the performance of the underlying stock, a convertible bond may behave more like a common stock or more like an option-free bond.

In its most basic form, a convertible bond represents a combination of an option-free bond and call option on the underlying common stock. Specifically, a convertible bond is a security that gives the investor the option to convert into a specified number of shares (adjusted for stock splits/stock dividends) of the issuer’s common stock. This differs from an exchangeable bond, which gives investors the option to exchange their bond for the common stock of a firm other than the issuer. Valuation of convertibles presents some challenges to the analyst. For example, the exercise price for the conversion option is surrendering a bond whose price changes. Moreover, convertible bonds issued ...