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January 29, 2025

Wednesday Investment Wisdom: Understanding Convertible Bonds and Their Risk Levels

by Detlef Glow.

Convertible bonds are unique financial instruments that combine elements of both fixed-income securities and equities. Since these instruments can offer unique payout profiles, they are often used for diversification within broad diversified portfolios.

Convertible bonds are issued by companies as a way to raise capital and provide investors with regular interest payments while offering the potential to convert the bonds into a predetermined number of shares of the company’s stock. The conversion from the bond to stock happens at specific times during the bond’s lifetime and is usually at the discretion of the bondholder. This dual nature makes them attractive to investors seeking both stability and growth opportunities. On the other side, convertible bonds are attractive for issuers since they normally offer a significantly lower interest rate than respective traditional corporate bonds.

Convertible bonds are also called hybrid securities, which makes it clearer that the price of a convertible bond is driven by more factors than just those for traditional bonds. That said, the price of convertible bonds is especially sensitive to changes in interest rates, the price of the underlying stock, and the issuer’s credit rating.

 

Key Features of Convertible Bonds

Convertible bonds function as traditional bonds, offering periodic interest payments and principal repayment at maturity. However, their standout feature is the conversion option, allowing bondholders to convert the bond into a specific number of shares of the issuing company’s stock. This conversion typically occurs at a predetermined price and within predetermined timeframe(s).

If the stock price appreciates significantly above the conversion price, the bondholder can convert the bond into equity and benefit from the stock’s growth. Conversely, if the stock price remains below the conversion price, the bondholder retains the bond, earning interest and will under normal circumstances get the principal back at maturity.

 

Risk Levels Based on Conversion Options

The risk profile of convertible bonds is heavily influenced by the bond’s relationship to its conversion price. This relationship is typically categorized into three scenarios: in the money, at the money, and out of the money.

  1. In the Money

When the stock price is significantly above the conversion price, the bond is considered in the money. In this scenario, the price of the convertible bond behaves more like equity, as any movement of the stock price is directly impacting the price of the convertible bond.

While the potential for upside is high, the bond becomes more exposed to equity market volatility, increasing its equity risk. However, the downside risk is somewhat mitigated by the so-called bond floor or the bond’s intrinsic value, which is essentially the par value of the bond, hence the amount the issuer has promised to repay the investor. This amount isn’t tied to the stock price.

Investors are likely to convert their bonds into the respective stock when a convertible bond is in the money.

  1. At the Money

When the stock price is near the conversion price, the bond is at the money. Here, the bond’s value is highly sensitive to movements in the stock price, making it more volatile. This scenario presents a mix of bond-like and equity-like risks. The market risk is elevated because small changes in the stock price can significantly impact the bond’s value. Investors must carefully evaluate the stocks potential to determine whether to convert or hold the bond.

  1. Out of the Money

When the stock price is below the conversion price, the bond is out of the money. In this case, the conversion option holds little to no value, and the bond functions primarily as a traditional fixed-income instrument. The risk profile shifts toward credit risk as the bond’s value depends on the issuer’s ability to meet interest and principal payments. Market risk and equity exposure are minimized in this scenario, but investors may still face liquidity risk if the bond is difficult to sell.

 

Conclusion

The risk levels of convertible bonds vary significantly based on the stock price relative to the conversion price. In the money bonds carry higher equity risk, while out of the money bonds behave more like traditional bonds with greater credit risk. Investors must consider the current dynamics of a convertible bond and align them with their investment strategy, asset allocation, and risk tolerance.

 

This article is for information purposes only and does not constitute any investment advice.

The views expressed are the views of the author, not necessarily those of LSEG Lipper or LSEG.

 

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