The hybrid nature of convertible debt provides investors with significant benefits – decreases in the equity price of the underlying asset are hedged against by the value of the bond, while increases in the equity price of the underlying asset can increase the value of the convertible debt. This paper highlights some key reasons why convertible debt is attractive to investors:

1.      Security of capital

While each convertible security is different, generally convertible debt sits ahead of equity and behind traditional debt in the event of a liquidation or bankruptcy, albeit at PURE most of our loans are senior secured, with no debt ranking ahead.

The priority of the debt is important from an investor point of view, as it sets the waterfall of repayments, and therefore the likelihood of them receiving their capital back, if the company goes into administration.

Of course, the value of security can be impacted by any of the following factors:

• whether the convertible debt is secured or unsecured
• the underlying credit worthiness of the company
• whether the investor has control as to when it converts into equity or if it needs to convert at all

2.      High and regular income

As with other forms of debt, convertible debt provides investors with a regular source of interest income.

The level of interest (or yield) for a convertible debt security is primarily determined by the creditworthiness of the borrower and the level of risk associated with the debt. Generally, the higher the creditworthiness of the borrower and the lower the risk, the lower the interest rate. Other factors that can impact the interest rate include the term of the debt, whether there is any security provided against the debt and the level of that security.

Unlike dividends paid to equity holders, which can be adjusted or even removed by the company at short notice, interest paid to convertible debt holders is contractual and will be paid as long as the company remains solvent.

Arguably, convertible debt provides an excellent vehicle for equity type investors who are looking for upside but are unsure when the catalyst for that upside will occur. In the meantime, convertible debt investors are ‘paid to wait’.

3.      Equity upside

A rising stock price can often not mean much to a bond holder, other than a sign that things are going well and the likelihood of them receiving their capital at the conclusion of the loan.

However, for convertible debt investors a rising stock price feeds directly through to the value of their equity option and their ability to generate capital growth in addition to interest.

4.      Stability of capital

Combining bond-like downside protection with an equity participation option has made convertibles one of the most reliable investments.

They have consistently delivered less volatility than stocks over the long term. If the price of the underlying equity falls, then its bond-like character can cushion the blow.

Furthermore, if the convertible bond is unlisted the likelihood of any pricing volatility pre-conversion is limited to only when there is a default on the debt.

5.      Superior returns

Over time, convertible debt has significantly outperformed conventional corporate and government bond and equity markets, delivering an annualised return of 7.9%.

Furthermore, major stock market crashes had a much smaller impact on convertible debt than on stocks, resulting in convertible bonds delivering lower volatility to investors than equities.

Sources: Credit Suisse, Bloomberg Returns hedged in US dollars, data range: December 31, 1997, to December 31, 2020, Indices: MSCI World, Refinitiv Convertible Global, ML Global Broad Market Corporate, JPM Broad Government Bond

6.      Equity Discount / Premium

An equity discount/premium is a feature of a convertible debt, which allows the bondholder to convert into a certain number of shares of the issuing company’s stock at a later date, at a discount or premium to the share price.

For example, if a company issues a convertible bond with an equity premium of 40%, that means that the bondholder can convert their bond into shares of the company’s stock at a price that is 40% higher the market price when issued. So, if the current market price of the stock is $1.00, the bondholder could convert their bond into shares at a price of $1.40.

If the convertible note has a three-year term and a 10% coupon, the investor can expect a 30% return while they wait to for the equity price to rise to a premium to the conversion price. If this occurs, they will make an equity return in addition to interest income. If the equity price does not improve sufficiently, the investor has made a reasonable return on the loan, which should then be repaid.

Some convertible notes can convert at a discount to a future share price. A conversion discount can seem more attractive than a premium, but as it is typically linked to a future share price, rather than a fixed share price, the equity upside will be limited to the value of the discount. Smaller companies can have extreme price movements, and so by fixing the conversion, even at a premium, if the company is successful the investor stands to make considerably more profit.

Expanding on the example above:

• If the price is fixed at $1.40 and over the three-year term, the share price doubles from $1.00 to $2.00 the investor will have made 42% profit at conversion, plus interest.
• If the conversion is at a 20% discount to a future share price, they would convert at $1.60 therefore making a 25% profit, plus interest.

In a more extreme example, if the price were to triple to $3.00, the fixed premium allows the investor to generate a 114% equity profit, but the discounted convertible profit would be the same at 25%.

Although, in theory the discounted bond allows the investor to make a profit on conversion even if the share price falls, in practise most discounted convertibles have a floor price (i.e. the lowest price the bond can be converted) and this can quickly be breached. Moreover, if the share price is falling, most bond holders elect to be repaid rather than convert into shares.

Convertible debt and asset allocation

While convertible debt has been issued for over 100 years, investors continue to debate whether it should be an asset allocation from an equity or fixed income viewpoint.

The data suggests that the sensitivity of equities has driven the performance on the upside, while the characteristics of fixed income have enabled superior performance on the downside.

The case for a convertible bond allocation remains strong, and convertible securities can provide diversification to reduce portfolio volatility. The hybrid characteristics make them a compelling choice for strategic allocations that pursue lower-volatility equity exposure over full and multiple market cycles.

In times of market stress, like the situation in small-companies today, they allow investors to invest knowing they are taking less risk than equities should the market fall further, but if the market rallies their investment will also increase in value.

Find out more about convertible debt and how it can work within your portfolio at PURE Asset Management.