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Created on 24.07.2019

Convertible bonds – bonds that can be converted into equities

Rising interest rates and greater fluctuations on the stock exchanges are making convertible bonds more attractive again. Many investors are anxious because various negative factors such as the trade war between the USA and China are causing market turmoil. A close eye needs to be kept on how interest rates will develop in future. Convertible bonds increasingly come into play in this context.

Convertible bonds are a special form of investment where bonds can be converted into equities of the issuing company. This type of bond is currently enjoying a boom – in 2018 companies worldwide issued convertible bonds worth over 100 billion dollars. This type of investment provides many benefits for investors in an uncertain market environment. Their potential returns are almost as high as those of shares, but they also offer the stability and regular interest income of corporate bonds. This means they are ideal for investors seeking to assume a low level of risk but who also wish to benefit in the event of rising equity prices.

The fixed-interest basis

Convertible bonds or convertibles are fixed-interest securities. They are issued by companies to raise capital and have a nominal value and a limited term. As with conventional corporate bonds, the holders of convertible bonds receive regular interest (coupons). The coupons of convertible bonds are lower than those of ordinary corporate bonds without a conversion right.

Bonds with a conversion right or mandatory conversion

This conversion right – which can also involve mandatory conversion depending on how the convertible bond is structured – is one of the key traits of convertible bonds. It means the holder has the right or is obliged to convert the bond into equities within a certain period of time. If the holder is obliged rather than entitled to convert the bond, this is known as a mandatory convertible bond. This is a special type of the standard convertible bond. Whereas investors have the choice of whether or not to convert into equities by the maturity date with conventional convertible bonds, they must convert into equities by the maturity date at the latest in the case of mandatory convertible bonds. As a result, investors bear a greater risk of suffering lower returns in the event of a fall in prices.

When conversion makes sense.

The lower limit of a bond is called the bond floor or bond value. This refers to the value of the bond without conversion rights over the same remaining time to maturity and interest. Every convertible bond contains the option to purchase an equity at a certain price. The value of this option obviously increases if the price of the equity rises. By contrast, if the equity price falls, then the value of the convertible bond also decreases towards the bond floor.

If the share price of convertible bonds lies above the strike price, they are deemed “in the money” and “out of the money” if it falls below this price. This comparison with the strike price makes it easier for investors to decide whether to exercise their conversion right or to let it expire.

The diagram shows how a convertible bond works compared with a share. The v line represents the value of the share/bond. It is separated in the middle by a horizontal line labelled “Bond value”. The share is represented by an orange line that moves diagonally upwards from the bottom left to the top right. The convertible bond is represented by a light-blue line. This starts in the bottom left in the section “Payment default”. This occurs when the bond is worth less than its face value. If it is worth the same as its face value, the bond is considered a bond-related bond. If it continues to increase in value, it first enters a “balanced” range until it is equity-related and behaves the same way as a share. The exercise price comes into play in the “balanced” range. If the share price is lower than the exercise price, it is “out of the money”, and “in the money” if it is higher.

Advantages and disadvantages of convertible bonds

As investments, convertible bonds offer the following advantages:

  • Payment of fixed interest until conversion and a dividend after conversion
  • An increase in the equity price of the underlying asset also increases the value of the convertible bond
  • Price falls of the underlying asset are hedged against by the nominal value of the bond (provided no mandatory conversion applies)
  • There is lower interest rate risk than with government or corporate bonds due to the conversion right
  • Protection against setbacks on the equity markets

Convertible bonds can have the following disadvantages for investors:

  • Lower interest rates for the bond component compared to bonds without conversion right
  • Capital increases by the limited company can result in losses for investors
  • Risk of the price of the underlying asset falling (mainly concerns bonds with mandatory conversion)
  • After successful conversion of the bond into equities, the creditor entitlement to repayment of the bond amount expires
  • Large denominations usually have to be purchased, which makes this form of investment relatively unattractive to private investors.
  • There is little liquidity available on the stock exchanges for private investors as few equities and convertible bonds are issued to private investors. It can be difficult to sell them on the stock market as trade is not brisk.

How to invest in convertible bonds

Investors who wish to buy convertible bonds can invest in them directly. There are now attractive funds that invest in convertibles. PostFinance also offers a bond fund that invests in global convertible bonds, which means it consists of a broadly diversified portfolio. The portfolio is made up of convertible bonds, convertible preference shares as well as mandatory convertibles and other convertible or exchangeable securities.

A good option for cautious investors

Convertible bonds are an exciting opportunity for cautious investors. They do not have to be invested directly in equities at the time of purchase but can use convertible bonds to benefit from developments on the stock markets. Convertible bonds are an ideal investment opportunity, especially at times when market trends are difficult to predict.

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