Weigh the risk and return profile of a convertible bond against the profiles of a straight bond and the underlying common shares
The idea
A convertible's behaviour depends on where the share price sits. When the share price is far below the conversion price, the convertible is busted: it trades near its straight value and behaves like a bond, driven by rates and credit. When the share price is far above, it behaves like the shares, with little premium. In between, it offers part of the equity's upside with a bond floor limiting losses. Compared with the stock, it gives up some upside for downside protection; compared with a straight bond, it pays a lower coupon for the equity option. On price alone it usually lags the shares on the upside, because its premium to conversion value shrinks as the shares rise.
In the app: 2 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →More in Valuation and Analysis of Bonds with Embedded Options
- Explain bonds and other debt securities that contain embedded options
- Explain how a callable or putable bond's value links to the value of its embedded option and of the equivalent straight bond
- Explain how to apply the arbitrage-free approach when valuing a bond that contains embedded options
- Explain the effect of interest rate volatility on what a callable or putable bond is worth
- Explain the effect of shifts in the yield curve's level and shape on what a callable or putable bond is worth
- Use an interest rate tree to work out what a callable or putable bond is worth
- Explain how option-adjusted spreads are computed and what they are used for
- Explain the effect of interest rate volatility on option-adjusted spreads
- Work out a callable or putable bond's effective duration and explain what it means
- Contrast the effective durations of straight, callable and putable bonds
- Explain how one-sided and key rate durations help assess the rate sensitivity of bonds that contain embedded options
- Contrast the effective convexities of straight, callable and putable bonds
- Work out what a floating-rate bond with a cap or a floor is worth
- Set out the key characteristics of a convertible bond
- Work out the parts that make up a convertible bond's value and explain what they mean
- Explain how to value a convertible bond within an arbitrage-free framework