Convertible bonds

Excellent risk/reward ratio

An investor collects regular coupon payments and receives the invested capital at maturity.

What differentiates a convertible bond from a straight bond is the embedded call option, to exchange the convertible bond into shares. As a result, convertible bonds perform partly like any bond instrument and partly like stocks.

Whenever it becomes advantageous for an investor, to exercise his right to exchange the bond into shares, the return profile of a convertible bond will resemble the profile of a stock. If the exercise is not attractive, the investor will decide not to exercise his right and will be paid back the initial capital at maturity.

Opportunities

As opposed to traditional fixed income securities, convertible bonds might show a positive performance in times of rising inflation. Although convertibles might not necessarily perform positively in such a scenario, an investor can profit if the stock market continues to perform well.

The combination of long term capital gains and capital protection by means of the repayment of the bond part is one of the main reasons why there is a rising trend for including convertible bonds in the institutional asset allocation.

Advantages of Convertible Bonds

  • Outstanding Risk/Return ratio
  • Offers investors opportunity to invest in closed markets (India, China)
  • Up in the hierarchy of the capital structure (Convertibles are usually repaid before shareholders)
  • Capital protection / Takeover ratchet in M&A situations
  • Equity participation with lower volatility
  • Yield advantage over conventional bonds

Risks

In every opportunity lies a risk – the main advantage of convertible bonds, their balanced risk profile implies a certain risk exposure to equities, credit spreads, interest rates, currency movements and equity volatility. Each one of these risk factors can influence the price behavior of a convertible negatively (example: falling equity markets, rising interest rates, rising credit spreads, falling volatilities).

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