Convertible Bond

Convertible Bond

In finance, a convertible note (a convertible debenture if it has a maturity of greater than 10 years) is a type of bond that the holder can convert into shares of common stock in the issuing company or cash of equal value, at an agreed-upon price. It is a hybrid security with debt- and equity-like features. Although it typically has a coupon rate lower than that of similar, non-convertible debt, the instrument carries additional value through the option to convert the bond to stock, and thereby participate in further growth in the company's equity value. The investor receives the potential upside of conversion into equity while protecting downside with cash flow from the coupon payments and the return of principal upon maturity.

From the issuer's perspective, the key benefit of raising money by selling convertible bonds is a reduced cash interest payment. The advantage for companies of issuing convertible bonds is that, if the bonds are converted to stocks, companies' debt vanishes. However, in exchange for the benefit of reduced interest payments, the value of shareholder's equity is reduced due to the stock dilution expected when bondholders convert their bonds into new shares.

The convertible bond markets in the United States and Japan are of primary global importance. These two domestic markets are the largest in terms of market capitalisation. Other domestic convertible bond markets are often illiquid, and pricing is frequently non-standardised.

• USA: It is a highly liquid market compared to other domestic markets. Domestic investors have tended to be most active within US convertibles
• Japan: In Japan, the convertible bond market is more regulated than other markets. It consists of a large number of small issuers.
• Europe: Convertible bonds have become an increasingly important source of finance for firms in Europe. Compared to other global markets, European convertible bonds tend to be of high credit quality.
• Asia (ex Japan): The Asia region provides a wide range of choice for an investor. The maturity of Asian convertible bond markets vary widely.
• Canada: Canadian convertible bonds are exchange traded. Most of the Canadian convertible bond market consists of unsecured sub-investment grade bonds with high yields that are reflective of the issuer's risk of default.

• Domestics versus Euroconvertible bonds A further important classification is between the domestic and euroconvertibles markets. Euroconvertibles pay their interest gross and are free of transfer duty when bought, and are delivered into Euroclear or Clearstream for 7 day settlement. Domestics may have different settlement dates, they may pay their interest net of tax and be subject to transaction taxes. European euroconvertibles are generally highly liquid and have a pan-European investor base, dominated by hedge funds and proprietary desks. European domestic convertibles (such as in the UK and Italy) are dominated more by local investment institutions. Since the early nineteen-eighties, foreigners have been able to receive interest on U.S. domestic convertible bonds gross, and this has broadened the global investor base to embrace global hedge funds and other global investors. Likewise, foreigners have been able to receive interest gross on French convertibles (obligations convertibles or OCs), further blurring the differentiation between the domestic and euro CB markets. The pan-European CB market has substantially replaced the various domestic CB markets, and the driver behind this has been the ability of cross-border investors to receive interest payments gross.

Convertible bond investors get split into two broad categories: Hedged and Outright investors. Hedged investors are those who will Buy or Sell the convertible bond, and take the opposite position in the common stock, a CDS contract, and potentially being combined with one of many options strategies. "Outright Investors" are those convertible investors who will own a convertible bonds with no hedge in place, thus taking on equity and credit risk of the issuing company. Outright Investors will buy convertible bonds and convertible preferred stock for their asymmetric payoff profile (A convertible may take part in 75% of the rise in the underlying common stock, but only 40% of the decline). While originally a market for outright investors, the convertible market had grown to be dominated by the hedged investors both in terms of ownership and trading volume, at potentially 70%. The credit crisis in 2008 caused this dynamic to shift when convertible hedge funds were forced by their banks to reduce their leverage employed, causing them to sell assets and shrink. The forced liquidations caused convertible securities to look particularly attractive and attracted "Crossover Buyers," or investors who cross over from the asset class of their primary focus into the convertible market. As of 2011, trading may be closer to 50/50 split between Hedged and Outright investors.