In finance, a convertible bond or convertible note or convertible debt (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.
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.
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 below the first conversion price the investor would suffer a capital loss compared to its original investment (excluding the potential coupon payments). Mandatory convertibles can be compared to forward selling of equity at a premium.
Exchangeable bond: Convertible bond where the issuing company and the underlying stock company are different companies (e.g. XS0882243453, GBL into GDF Suez). This distinction is usually made in terms of risk i.e. equity and credit risk being correlated: in some cases the entities would be legally distinct, but not considered as exchangeable as the ultimate guarantor being the same as the underlying stock company (e.g. typical in the case of the Sukuk, Islamic convertible bonds, needing a specific legal setup to be compliant with the Islamic law).
North America: About 50% of the global convertible market, mostly from the USA (even if Canada is well represented in the Material sector). This market is more standardised than the others with convertible structures being relatively uniform (e.g. Standard Make-Whole take over features, Contingent Conversion @ 130%). Regarding the trading, the American convertible market is "centralised" around TRACE which helps in terms of price transparency. One other particularity of this market is the importance of the Mandatory Convertibles and Preferred especially for Financials (about 10-20% of the issuances in the US regional benchmarks). Most of the trading operation are based in New-York.
Japan: This region represents about 8% of the total market as of January 2013 in spite of being in the past comparable in size to the Northern American market. It mostly shrunk because of the low interest environment making the competitive advantage of lowering coupon payment less appealing to issuers. One key specificity of the Japanese market is the offering price of issuance being generally above 100, meaning the investor would effectively bear a negative yield to benefit from the potential equity underlying upside. Most of the trading is done out of Tokyo (and Hong-Kong for some international firms).
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.
Convertible bonds are mainly issued by start-up or small companies. The chance of default or large movement in either direction is much higher than well-established firms. Investors should have a keen awareness of significant credit risk and price swing behavior associated with convertible bonds. Consequently, Valuation models need to capture credit risk and handle potential price jump.
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.