Trading Patterns of Convertible Bonds

The basic premise behind a convertible bond is that it enables the holder to obtain exposure to a company s equity. It follows, then, that a buyer should have a positive view of the company s future prospects. On issue, a convertible bond s price behavior will be a function of the underlying equity price, the credit quality of the issuer, and the prevailing interest rate. The price action of the equity determines how an investor will view the convertible. Depending on this price action, convertible bond trade patterns generally follow one of three types. They may move from one type to another during their life, as the fortunes of the underlying equity fluctuate. A discussion of these patterns follows. 

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. 

These bonds can behave later like equity investments or yield investments depending on how the share price performs subsequently. 

A negative yield to maturity is common for equity exposure bonds and indicates that the redemption price is lower than the current bond price and coupon value to redemption. Notwithstanding this, equity alternatives 

When evaluating convertible securities, the investor will consider the expected performance of the underlying shares, the future prospects of the company itself, and the relative attraction of the bond as a pure fixed-income instrument in the event that the conversion feature proves to be worthless. The investor will also take into account the credit quality of the issuer, the yield give-up suffered as a result of purchasing the convertible over a conventional bond, the conversion premium ratio, and the fixed-income advantj e gained over a purchase of the underlying shares in the first place. 

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