Convertible bonds are just junk bonds that give the holders the option of exchanging the bonds for stocks at a given conversion price per share based on par.
Companies usually add the conversion feature to their junk bonds to juice up the offer but lower the bond yield to save in interest payments and to avoid diluting earnings if additional stocks are issued.For example,instead of issuing a $1,000-par junk bond with 12% interest rate a company may offer a convertible bond of 6% interest with a conversion price of $25/share based on par;while the current company stock price is $20.By doing this way the company can save 50% on interest expense and does not worry about diluting its outstanding stocks because if the bondholders convert the bonds into stocks now they will suffer a loss of $200 per bond.Bond buyers are motivated because they hope the company’s stock price will increase.Furthermore, on the investor’s standpoint,buying this bond is like buying $800 of 6%-interest bond and an out-the-money call option at $25 strike price with no expiration date.On the upside if the stock rises pass $25 the investor enjoy both the interest income and the capital gain.On the downside the investor can still has the interest payments and get back his/her full principal at maturity,the call option is no-cost.Unless the company gets defaulted,this is clearly a win-win deal.
There are a few things worth to be considered in trading convertible bonds:
Force Conversion: the company can call to force the conversion of its convertible bonds into its stocks and replace interest payment by dividend if the company wants to release itself from legal obligation and interest payment load.Notice that dividend is paid at company’s discretion while interest payment is an obligation.
Conversion price: bond price can change due to bond rating adjustment and market interest rates move,etc.,stock price can change due to investor’s expectation and other factors,etc., but the conversion price based on par is fixed;it is only adjusted for stock split or stock dividend.Conversion ratio is par value divided by conversion price.In the above example,conversion ratio is 1,000/25 = 40:1
Parity prices: there are two parity prices should be noted-the parity price of bond and the parity price of stock.They’re defined:
Parity price of bond = market stock price x conversion ratio
As in the above example:
Parity price of bond = $20 x 40 = $800;
Parity price of stock = market bond price/conversion ratio
Suppose the market bond price now is $900
Parity price of stock = 900/40 = $22.5
These two formulas help investors quickly realize the disparities of bond price and stock price to act accordingly.For example,the market bond price goes up to $1,100 and the stock price goes up to $30,one can buy the bond and sell short the equivalent number of stocks (40 shares) for profit.It’s called arbitrage trading.Arbitrage is spotted when market bond price ($1,100) falls below parity price of bond ($30×40 = $1,200)
Also notice that when the bond price is at premium (above par value) its price moves in lock steps with market stock price,when the bond price at discount (below par) its price behaves like normal bonds.
Invest in convertible bonds requires a little research of the company.First check its balance sheet to know its total assets and liabilities,read the financial statement to see if earnings before ,interest,tax,amortization (EBITA) are high enough to keep it in operation,check its current net working capital (cash+cash equivalent+receivables are larger than current liability),check if tangible assets are larger than long term debt(remember to add the new debt due to issuing the new convertible bonds),if everything is fine then the company fundamental is O.K.,then check the company’s credit rating by the three major investment rating companies (S&P,Moody’s,Fitch),at least two of them;if the ratings tilt toward the higher end (BB and Ba or higher) then the default risk is far from the horizon (probability of default in this ratings is very low). Periodical monitors are still needed as long as the bond is hold. Trading bond in general is carried out with the help of a brokerage because the bond market is thin and slow.It is better for individual to find a bond fund with specialty in convertibles that helps to diversify the investment.