Convertible bonds bond floor

Convertible bonds give a risk premium above the bond floor, that is the excess of the convertible bond price above the option-free bond price (Figure 9.3). 

As explained in the introduction, the value of a convertible bond is the sum of two main components, the option-free bond and a call option on underlying security. The value of the option-free bond, or bond floor, is determined as the sum of future payments (coupon and principal at maturity). Therefore, the bond component is influenced by three main parameters, that is the maturity, the coupon percentage on par value and the yield to maturity (discount rate). Differently, the value of a call option can be found mainly through two option pricing models, Black Scholes model and binomial tree model. 

In contrast, an increasing conversion premium decreases the value of the convertible. For instance, a conversion premium of 60% the convertible bond prices around 100. Therefore, increasing the conversion premium the option element decreases, and the convertible bond prices with values closed to the bond floor. 

After bond issue, the implied premium fluctuates overtime mainly due to the market movements of the stock price. In fact, the bond floor is enough stable during the convertible bond s life and the change of the convertible prices are due to the moves of the underlying asset. 

The option element in a convertible cannot be stripped out of the bond element, and so is termed an embedded option. The valuation of the bond takes into account this embedded optionality. Note also that unlike a straight equity option, there is no additional payment to make on conversion the holder simply exchanges the bond for the specified number of shares. One could view the price paid for exercising the option as being the loss of the bond element, which is the regular coupon and redemption proceeds on maturity, but this should be viewed as more of an opportunity cost rather than a payment. This bond element is often referred to as the bond floor, which is the straight debt element of the convertible. The bond floor can be viewed as the level at which a vanilla bond issued by the same company would trade, that is, its yield and price. It generally accounts for between 50 percent and 80 percent of the total value. 

Total return investment Most convertibles are issued as total return instruments, with the investor considering both the bond yield and the conversion premium on the equity. They will continue to trade like this unless the equity moves strongly either up or down. As a total return investment, the bond will exhibit roughly symmetrical conversion premiums. Its price is sensitive to both movements in the price of the underlying equity and market views on the credit outlook of the company. If the share price rises, the conversion option value increases as the conversion premium decreases, although at a slower rate compared to the equity itself. The reverse occurs if the share price falls, but the bond has downside protection, so as it approaches its bond floor, it outperforms the share and becomes less sensitive to movements in the share price. 

Investors are concerned with the point at which the ratio of the parity of the bond to the investment value moves far above the bond floor. At this point the security trades more like equity than debt, the equity exposure investment we described earlier. The opposite to this is when the equity price falls to low levels, to the point at which it will need to appreciate by a very large amount before the conversion option has any value at this point, the convertible trades as a yield investment. 

We then take the analysis further for a convertible bond plus its embedded option. FIGURE 13.8 shows the price tree for the conventional bond where the share price and conversion price is equal to 100 in the current time period. Note how the conventional bond element of the convertible provides a floor for its price in later periods. 

For convertible bonds, delta is defined in terms of the sensitivity of the bonds price to changes in its parity. The parity is given from the value of the underlying equity price. The value of this delta can be gauged from FIGURE 13.9, which illustrates parity and bond floor. The delta is seen from the relationship of the parity and note price. 

The Pioneer Centre, a Grade II listed structure, was converted to a residential home and it was necessary to introduce a number of staircases to connect the split levels of each unit. The concrete floor was relatively thin (152 mm) and the slabs were strengthened in flexure by bonding 1.2 mm thick pultruded Sika Carbodur laminates onto the bottom and top surfaces of the carefully cleaned concrete substrate prior to cutting the requisite openings (Figure 23.62). 

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