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In finance, a convertible bond, or convertible note, or a convertible debenture if it has a maturity of greater than 10 years, is a type of bond that the holder can convert into a specified number of shares of common stock in the issuing company or cash of equal value. It is a hybrid security with debt- and equity-like features. It originated in the mid-19th century, and was used by early speculators such as Jacob Little and Daniel Drew to counter market cornering. Convertible bonds are most often issued by companies with a low credit rating and high growth potential.
To compensate for having additional value through the option to convert the bond to stock, a convertible bond typically has a coupon rate lower than that of similar, non-convertible debt. 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. These properties lead naturally to the idea of convertible arbitrage, where a long position in the convertible bond is balanced by a short position in the underlying equity.
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.
Structure and features 
Like any typical bond, convertible bonds have an issue size, issue date, maturity date, maturity value, face value and coupon. They also have the following additional features:
- Conversion price: The nominal price per share at which conversion takes place.
- Conversion ratio: The number of shares each convertible bond converts into. It may be expressed per bond or on a per centum (per 100) basis.
- Parity (Conversion) value: Equity price × Conversion ratio.
- Conversion premium: Represent the divergence of the market value of the CB compared to that of the parity value.
- Call features: The ability of the issuer (on some bonds) to call a bond early for redemption, sometimes subject to certain share price performance. The intention is to encourage investors to convert early into equity (which has now become worth more than the bond's face value), by threatening repayment in cash for what is now a lower amount.
- Put features: The ability of the holder of the bond (the lender) to force the issuer (the borrower) to repay the loan at a date earlier than the maturity. These often occur as windows of opportunity, every three or five years and allow the holders to exercise their option to put for a certain number of days (30 days)
Markets and Investor profiles 
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.
The underwriters have been quite innovative and provided various variations of the initial convertible structure. Although no clear classification formally exists in the financial market it is possible to segment the convertible universe into the following sub-types:
- Vanilla convertible bonds are the most plain convertible structures. They grant the holder the right to convert into certain amount of shares determined according to a conversion price determined in advance. They may offer coupon regular payments during the life of the security and have a fixed maturity date where the nominal value of the bond is redeemable by the holder. This type is the most common convertible type and is typically providing the asymmetric returns profile and positive convexity often wrongly associated to the entire asset class: at maturity the holder would indeed either convert into shares or request the redemption at par depending on whether or not the stock price is above the conversion price.
- Mandatory convertibles are a common variation of the vanilla subtype, especially on the US market. Mandatory convertible would force the holder to convert into shares at maturity - hence the term "Mandatory". Those securities would very often bear two conversion prices, making their profiles similar to a "risk reversal" option strategy. The first conversion price would limit the price where the investor would receive the equivalent of its par value back in shares, the second would delimit where the investor will earn more than par. Note that if the stock price is bellow the first conversion price the investor would suffer a capital loss compared to its original investment (excluding the potential coupon payments).
- Reverse convertibles are a less common variation, mostly issued synthetically. They would be opposite of the vanilla structure: the conversion price would act as a knock-in short call option: as the stock price drops below the conversion price the investor would start to be exposed the underlying stock performance and no longer able to redeem at par its bond. This negative convexity would be compensated by a usually high regular coupon payment.
- Packaged convertibles or sometimes "Bond + Option" structures are simply a straight bonds and a call option/warrant wrapped together. Usually the investor would be able to then trade both legs separately. Although the initial payoff is similar to a plain vanilla one, the Packaged Convertibles would then have different dynamics and risks associated with them since at maturity the holder would not receive some cash or shares but some cash and potentially some share. They would for instance miss the modified duration mitigation effect usual with plain vanilla convertibles structures.
- See also Bond option: Embedded options, for further detail.
In theory, the market price of a convertible debenture should never drop below its intrinsic value. The intrinsic value is simply the number of shares being converted at par value times the current market price of common shares.
The 3 main stages of convertible bond behaviour are:
- In-the-money convertible bonds
- At-the-money convertible bonds
- In-the-money: Conversion Price is < Equity Price.
- At-the-money: Conversion Price is = Equity Price.
- Out-the-money: Conversion Price is > Equity Price.
- In-the-money CB's are considered as being within Area of Equity (the right hand side of the diagram)
- At-the-money CB's are considered as being within Area of Equity & Debt (the middle part of the diagram)
- Out-the-money CB's are considered as being within Area of Debt (the left hand side of the diagram)
- the underlying stock volatility to value the option and
- the credit spread for the fixed income portion that takes into account the firm's credit profile and the ranking of the convertible within the capital structure.
Using the market price of the convertible, one can determine the implied volatility (using the assumed spread) or implied spread (using the assumed volatility).
This volatility/credit dichotomy is the standard practice for valuing convertibles. What makes convertibles so interesting is that, except in the case of exchangeables (see above), one cannot entirely separate the volatility from the credit. Higher volatility (a good thing) tends to accompany weaker credit (bad). In the case of exchangeables, the credit quality of the issuer may be decoupled from the volatility of the underlying shares. The true artists of convertibles and exchangeables are the people who know how to play this balancing act.
A simple method for calculating the value of a convertible involves calculating the present value of future interest and principal payments at the cost of debt and adds the present value of the warrant. However, this method ignores certain market realities including stochastic interest rates and credit spreads, and does not take into account popular convertible features such as issuer calls, investor puts, and conversion rate resets. The most popular models for valuing convertibles with these features are finite difference models such as binomial and trinomial trees.
- Binomial valuations Since 1991-92, most market-makers in Europe have employed binomial models to evaluate convertibles. Models were available from INSEAD, Trend Data of Canada, Bloomberg LP and from home-developed models, amongst others.
- These models needed an input of credit spread, volatility for pricing (historic volatility often used), and the risk-free rate of return. The binomial calculation assumes there is a bell-shaped probability distribution to future share prices, and the higher the volatility, the flatter is the bell-shape. Where there are issuer calls and investor puts, these will affect the expected residual period of optionality, at different share price levels. The binomial value is a weighted expected value, (1) taking readings from all the different nodes of a lattice expanding out from current prices and (2) taking account of varying periods of expected residual optionality at different share price levels.
- The three biggest areas of subjectivity are (1) the rate of volatility used, for volatility is not constant, and (2) whether or not to incorporate into the model a cost of stock borrow, for hedge funds and market-makers. The third important factor is (3) the dividend status of the equity delivered, if the bond is called, as the issuer may time the calling of the bond to minimise the dividend cost to the issuer.
Uses for investors 
- Convertible bonds are usually issued offering a higher yield than obtainable on the shares into which the bonds convert.
- Convertible bonds are safer than preferred or common shares for the investor. They provide asset protection, because the value of the convertible bond will only fall to the value of the bond floor. At the same time, convertible bonds can provide the possibility of high equity-like returns.
- Also, convertible bonds are usually less volatile than regular shares. Indeed, a convertible bond behaves like a call option. Therefore, if C is the call price and S the regular share then
In consequence, since we get , which implies that the variation of C is less than the variation of S, which can be interpreted as less volatility.
- The simultaneous purchase of convertible bonds and the short sale of the same issuer's common stock is a hedge fund strategy known as convertible arbitrage. The motivation for such a strategy is that the equity option embedded in a convertible bond is a source of cheap volatility, which can be exploited by convertible arbitrageurs.
- In limited circumstances, certain convertible bonds can be sold short, thus depressing the market value for a stock, and allowing the debt-holder to claim more stock with which to sell short. This is known as death spiral financing.
Redemption options/strategies 
- Soft put - can be redeemed for cash, stock or notes or a combination of all three at the company's discretion.
- Hard put - payable only in cash
- Protective put - buying a put option for the underlying bond security
- Subordinated put -
- Convertible put - convert to share by paying a charge
Uses for issuers 
- Lower fixed-rate borrowing costs. Convertible bonds allow issuers to issue debt at a lower cost. Typically, a convertible bond at issue yields 1% to 3% less than straight bonds.
- Locking into low fixed–rate long-term borrowing. For a finance director watching the trend in interest rates, there is an attraction in trying to catch the lowest point in the cycle to fund with fixed rate debt, or swap variable rate bank borrowings for fixed rate convertible borrowing. Even if the fixed market turns, it may still be possible for a company to borrow via a convertible carrying a lower coupon than ever would have been possible with straight debt funding.
- Higher conversion price than a rights issue strike price. Similarly, the conversion price a company fixes on a convertible can be higher than the level that the share price ever reached recently. Compare the equity dilution on a convertible issued on, say, a 20 or 30pct premium to the higher equity dilution on a rights issue, when the new shares are offered on, say, a 15 to 20pct discount to the prevailing share price.
- Voting dilution deferred. With a convertible bond, dilution of the voting rights of existing shareholders only happens on eventual conversion of the bond. However convertible preference shares typically carry voting rights when preference dividends are in arrears. Of course, the bigger voting impact occurs if the issuer decides to issue an exchangeable rather than a convertible.
- Increasing the total level of debt gearing. Convertibles can be used to increase the total amount of debt a company has in issue. The market tends to expect that a company will not increase straight debt beyond certain limits, without it negatively impacting upon the credit rating and the cost of debt. Convertibles can provide additional funding when the straight debt “window” may not be open. Subordination of convertible debt is often regarded as an acceptable risk by investors if the conversion rights are attractive by way of compensation.
- Maximising funding permitted under pre-emption rules. For countries, such as the UK, where companies are subject to limits on the number of shares that can be offered to non-shareholders non-pre-emptively, convertibles can raise more money than via equity issues. Under the UK’s 1989 Guidelines issued by the Investor Protection Committees (IPCs) of the Association of British Insurers (ABI) and the National Association of Pension Fund Managers (NAPF), the IPCs will advise their members not to object to non pre-emptive issues which add no more than 5pct to historic non-diluted balance sheet equity in the period from AGM to AGM, and no more than 7.5pct in total over a period of 3 financial years. The pre-emption limits are calculated on the assumption of 100pct probability of conversion, using the figure of undiluted historic balance sheet share capital (where there is assumed a 0pct probability of conversion). There is no attempt to assign probabilities of conversion in both circumstances, which would result in bigger convertible issues being permitted. The reason for his inconsistency may lie in the fact that the Pre Emption Guidelines were drawn up in 1989, and binomial evaluations were not commonplace amongst professional investors until 1991-92.
- Premium redemption convertibles such as the majority of French convertibles and zero-coupon Liquid Yield Option Notes (LYONs), provide a fixed interest return at issue which is significantly (or completely) accounted for by the appreciation to the redemption price. If, however, the bonds are converted by investors before the maturity date, the issuer will have benefited by having issued the bonds on a low or even zero-coupon. The higher the premium redemption price, (1) the more the shares have to travel for conversion to take place before the maturity date, and (2) the lower the conversion premium has to be at issue to ensure that the conversion rights are credible.
- Takeover paper. Convertibles have a place as the currency used in takeovers. The bidder can offer a higher income on a convertible than the dividend yield on a bid victim’s shares, without having to raise the dividend yield on all the bidder’s shares. This eases the process for a bidder with low-yield shares acquiring a company with higher-yielding shares. Perversely, the lower the yield on the bidder’s shares, the easier it is for the bidder to create a higher conversion premium on the convertible, with consequent benefits for the mathematics of the takeover. In the 1980s, UK domestic convertibles accounted for about 80pct of the European convertibles market, and over 80pct of these were issued either as takeover currency or as funding for takeovers. They had several cosmetic attractions.
- The pro-forma fully diluted earnings per share shows none of the extra cost of servicing the convertible up to the conversion day irrespective of whether the coupon was 10pct or 15pct. The fully diluted earnings per share is also calculated on a smaller number of shares than if equity was used as the takeover currency.
- In some countries (such as Finland) convertibles of various structures may be treated as equity by the local accounting profession. In such circumstances, the accounting treatment may result in less pro-forma debt than if straight debt was used as takeover currency or to fund an acquisition. The perception was that gearing was less with a convertible than if straight debt was used instead. In the UK the predecessor to the International Accounting Standards Board (IASB) put a stop to treating convertible preference shares as equity. Instead it has to be classified both as (1) preference capital and as (2) convertible as well.
- Nevertheless, none of the (possibly substantial) preference dividend cost incurred when servicing a convertible preference share is visible in the pro-forma consolidated pretax profits statement.
- The cosmetic benefits in (1) reported pro-forma diluted earnings per share, (2) debt gearing (for a while) and (3) pro-forma consolidated pre-tax profits (for convertible preference shares) led to UK convertible preference shares being the largest European class of convertibles in the early 1980s, until the tighter terms achievable on Euroconvertible bonds resulted in Euroconvertible new issues eclipsing domestic convertibles (including convertible preference shares) from the mid 1980s.
- Tax advantages. The market for convertibles is primarily pitched towards the non taxpaying investor. The price will substantially reflect (1) the value of the underlying shares, (2) the discounted gross income advantage of the convertible over the underlying shares, plus (3) some figure for the embedded optionality of the bond. The tax advantage is greatest with mandatory convertibles. Effectively a high tax-paying shareholder can benefit from the company securitising gross future income on the convertible, income which it can offset against taxable profits.
2010 U.S. Equity-Linked Underwriting League Table 
|Rank||Underwriter||Market Share (%)||Amount ($m)|
|2||Bank of America Merrill Lynch||15.3||$5,369.23|
|3||Goldman Sachs & Co||12.5||$4,370.56|
|5||Deutsche Bank AG||7.8||$2,748.52|
|10||Jefferies Group Inc||4.3||$1,522.50|
See also 
- Jerry W. Markham (2002). A Financial History of the United States: From Christopher Columbus to the Robber Barons. M. E. Sharpe. p. 161. ISBN 0-7656-0730-1.
- "Introduction to Canadian Convertible Debentures". Voya Vasiljevic, ScotiaMcLeod. March 13, 2009. Retrieved March 13, 2009.
- Convertible Note Term Sheet Generator from Wilson Sonsini Goodrich & Rosati
- Pricing Convertible Bonds using Partial Differential Equations - by Lucy Li
- Pricing Inflation-Indexed Convertible Bonds - by Landskroner and Raviv
- Convertible Bond on Wikinvest