Introduction to Convertible Bonds
Convertible bonds consist of the bonds that are easily converted into the stocks. These convertible bonds are issued by the company and like any other normal bonds it has maturity date and face value. The convertible bondholder has all the rights of converting the bond into the predetermined share numbers of the respective company in an identified period. The factors influencing the bondholder converting or not depend on the stock interest rates and prices.
Contract conditions and Payoffs
The convertible bonds market conditions are not standardized and hence making it differ depending on every contract case. The maturity date being one of the convertible bonds features, it indicates the date of having the face value being returned. This happens if maturity date has not converted the bonds. The convertible bonds contract conditions are based on the face value, conversion value and the ratio (Werner 31). The time or period of convertible bonds conversion has great importance in the contract. According to European contract, the convertible bonds cannot be traded on the market expecting the possible conversion to happen in a single day. Furthermore, in the American contract, convertible bonds can be converted any time. In most cases, the convertible bonds are usually converted in a predetermined period that can last for two months to years depending on the contract conditions.
The Bermudan type of convertible bonds has a discrete number of conversion occasions. The most important conversion condition to notice is the existence of sometime between the bond conversion and maturity date. This makes it more complicated in decision making regarding bond conversion as the face value is always received at a later date. The coupon payments on convertible bonds are similar to the ordinary bonds whereby the bonds holder receives it from the issuing company (Dorion, François and Grass 44). The number of the coupon payment per year differs depending on the convertible bonds market and contract, but the standard is once coupon payment per year. Furthermore, the interest influencing coupons are determined in advance or floating market rate.
The convertible bond payoff represents the different conversion rates. They include;
Declining payoff zone: at this zone, there is full 100 percent participation whereby the convertible bonds are below the indicated strike prices. The zone is indicated as the stable conversion ratio.
Stable payoff zone: the zone exists between the upper and lower strike prices. The conversion value is considered to be equivalent to the issue price regardless the increasing stock prices. The zone represents or reflect declining conversion ratio.
Increasing payoff zone: The region consists of increased stock price over the upper strike price. The zone indicates stable conversion that is at a lower level compared to the average conversion ratio provided in the declining conversion zone.
Convertible bonds users and the reasons
The convertible bonds are issued by the company to employees mainly for two reasons. The convertible bonds are issued to motivate employees to work hard and as the bonus. The convertible bonds have advantages over the stock option as it guarantees employees payback (Brown 8). Furthermore, the company issues new convertible bonds and shares to the stakeholders that are shareholders and investors with the aim of raising money for financing its activities. The importance of issuing convertible bonds is delaying dilution effect. Dilution is experienced when the company introduces new shares making the total number of the stocks increasing and hence decreasing the profit expected per stock.
Convertible Bond Pricing and Hedging
Different consideration and variables influences convertible bond pricing. These pricing factors vary from contract condition on stock pricing, date of dividends, stock volatility, interest rate and the correlation between the interest rate and stock price. The convertible bond pricing behaviors are different as they depend on the stock price. Various technical methods are used in valuing convertible bonds that go beyond exploring pricing methodologies guides (Yan, Yi and Yang 68). The major elements to consider are the coupon and the initial conversion prices. Initial conversion prices depend on with the volume weighted average prices-VWAP of the ordinary shares issued by the company. This is related to the announcement or launch of the offers and convertible bonds pricing (Werner 98). Furthermore, the conversion premium contributes in determining the conversion price of convertible bonds. In hedging, the correlation that exists between the coupon payable and a conversion premium of convertible bonds is important.
Special or interesting features
Convertible bonds tend to bear different features that are associated with the issuer needs. These features include:
Call features; this is defined as the ability of the issuer in calling early redemption of the bond. This happens under obliged circumstances whereby the issuer considers the bond performance and conversion price on a specific date. Under the call features, there is soft and hard call whereby the soft call features consider stock price performance and hard call features consider the only date and Call price at a specific date (Dorion, François and Grass 54).
Put features; this is the ability of bondholder forcing the issuer to have the loan repaid earlier than the maturity date. It is under the windows of opportunity whereby the holder has the right to exercise early repayment that is in every three or five years.
Contingent conversion; it indicates the restricted ability of convertible bond conversion whereby the bondholder cannot convert bonds into equities. The restrictions are formulated on the basis o stock price or time (Yan, Yi and Yang 74).
Reset: regarding the underlying stock performance, the conversion prices might reset to the new value. This can be caused by underperformance especially when the stock price is considered to be below 50 percent of the conversion price.
Control event change; the conversion prices can be readjusted if the takeover is experienced in the company. The approach takes different formula such as time dependent and make-whole base that contributes to small or significant effects and impacts to the convertible bond holder. This provides the convertible bond holder a chance to exercise their ability to ask for early repayment.
In conclusion, convertible bonds like any other financial instrument play a major role in the stock market. The investors consider convertible bonds as they are safer compared to other preferred and common shares. Convertible bonds provide assets protection as their values tend to fall to that of the bond floor. Furthermore, in most cases, convertible bonds have tenderness or possibility o having higher returns compared to other stocks. The pricing strategies applied in conversion bond helps in reducing the financial risks that are transferable from financial instrument to another. Therefore, convertible bonds are safer compared to other stocks as investors undertake conversion depending on the prevailing market price and maturity date.
Works Cited
Brown, Mayer. "Convertible Bonds." An Issuer’s Guide (European Edition) (2013): 1-22. Web
Dorion, Christian, et al. "Convertible debt and shareholder incentives." Journal of Corporate Finance 24 (2014): 38-56. Print
Werner, Sebastian. Short Selling Activities and Convertible Bond Arbitrage: Empirical Evidence from the New York Stock Exchange. Germany: GWV Fachverlage GmbH, 2010. Print.
Yan, Huiwen, et al. "Dynkin game of convertible bonds and their optimal strategy." Journal of Mathematical Analysis and Applications 426.1 (2015): 64-88. Web
