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Allianz Global Investors

Understanding convertible bonds


Investor
Education September 30, 2015

What is a convertible bond? The example below shows how these terms might apply to an actual con-
By definition, a convertible bond is a corporate bond that can be vertible bond issue.
exchanged by the holder into a predetermined number of shares of How do convertible bonds fit into an investment portfolio?
the issuers common stock. Like other bonds, convertibles pay interest As part of a long-term asset allocation strategy, convertibles can enhance
at a fixed coupon rate and can be redeemed at the face (or par value) portfolio diversification, because they dont tend to move in unison with
of the bond. They also fluctuate in price with changes in interest rates and either stocks or bonds.
credit worthiness of the issuing company, just like other types of corpo-
rate bonds. For income-oriented equity investors, the coupon paid on convertibles
tends to be higher than the dividend yield of the companys common
In return for the conversion feature, convertible bonds generally carry a shares. Convertible securities have offered equity-like returns, with
lower coupon rate than nonconvertible corporate bonds; however, the less volatility.
interest rate usually offers a yield advantage over the common stock
dividend rate. When convertible bonds mature, they can be redeemed For fixed-income investors, convertible bonds can add growth potential to
at their face valueor at the market value of the underlying common a portfolio of bonds. The ability to convert into common shares could be
shareswhichever is higher. especially attractive to fixed-income investors concerned about the ero-
sive effects of rising interest rates and inflationary pressures.
The terms of the conversion feature specified when the bond is issued,
the conversion ratio and price, are defined below: Advantages of convertible bond investment
The conversion ratio is the number of common shares into which a con- Convertible bonds aim to participate in the upside potential of the equity
vertible bond can be converted . market while limiting exposure to downside volatility. Generally, total
return convertible bonds have captured 60-80% of the upside of the
The conversion price is equal to the face value of the bond divided by underlying equity versus 50% or less of the downside.
the conversion ratio.
What are the risks of investing in convertible bonds?
Once a bond is issued, the amount by which the convertible price exceeds
Convertible bonds are subject to the risks of both stocks and bonds and
the conversion value is referred to as the conversion premium, expressed
are not suitable for all investors. These bonds can fluctuate in value with
as a percentage. The conversion value, also known as the parity, is equal
the price changes of the companys underlying stock. If interest rates rise,
to the number of shares represented in the conversion ratio multiplied by
the value of the corresponding convertible bond will fall. Many of the
the common share price.
companies that issue convertible bonds are below investment grade,
which means the bonds can be more risky than investment-grade issues.
EXAMPLE Convertible bonds are often issued by smaller companies and may be
more volatile than securities issued by larger companies.
A
 $1,000 bond, at new issues, with a conversion ratio of 40:1
would convert into 40 shares of stock at a conversion price Where does convertible bond fit in the capital structure?
of $25.
Typically, convertible bonds are senior unsecured debt, which is senior to
If the underlying stock is trading at $20, the conversion
common equity and junior to secured debt.
premium would represent $5/share, or 25%.
The conversion value would be $800.

us.allianzgi.com
Investor Education | Understanding convertible bonds

Convertible bond behavior is it a bond or a stock? Equity Sensitive Convertibles in this category behave very close to a
At any given point in time, the trading behavior of a convertible bond can pure equity investment, characterized by lower yields/conversion pre-
take on either stock or bond characteristics. Depending upon where the miums and a high degree of equity sensitivity.
underlying stock is trading in relation to the bonds conversion price.
Convertible universe historical conversion premium
As the chart (below) illustrates, the security becomes more stock-like as
120
the price of the common shares rises which means that its participation
110
in the stocks upside potential tends to increase.
100
As the underlying stock price falls, the convertible becomes more bond-
90
like. If the stock price slips below the conversion price, the convertible
80
trades just like a bond, effectively putting a price floor under the invest-

Conversion Premium (%)


ment. It is important to note that convertibles are also subject to the 70

same risk factors as stocks and bonds including market, interest rate 60
and default risks. 50

40
Participation potential, volatility cushioning
30

Busted Total Return/Balanced Equity Sensitive 20

10
Appreciation 0
Potential of a Stock
Protects 90 92 94 96 98 00 02 04 06 08 10 12 14 15
Convertible Price

19 19 19 19 19 20 20 20 20 20 20 20 20 20
Like a Bond
Note: Convertibles universe is based on the BofA Merrill Lynch All US Convertibles Index
100 Source: BofA Merrill Lynch; Allianz Global Investors. Data as of 9/30/2015.

Over the long-term, how have convertibles performed


relative to stocks and bonds?
Conversion Value Historically, convertibles have delivered attractive asymmetric returns
Bond Value
Convertible Price that is, they have participated in more of the underlying stocks upside
than its downside. Since 1988, convertibles have posted returns that were
0 similar to stocks but with reduced volatility.
Stock Price

Note: Hypothetical example-not representative of any specific convertible. Convertibles Risk / Reward
involve the risk factors of both stocks and bonds. They fluctuate in value with the price January 1988 to September 2015
changes of the underlying stock. If interest rates on the bonds rise, the value of the cor-
responding convertible will fall. Funds that invest in convertibles may have to convert 12
the securities before they would otherwise, which may have an adverse effect on the
Stocks
Funds ability to achieve its investment objective. Source: Allianz Global Investors; see
additional disclosure. 10

What is the conversion premium? Convertibles


Return (% Annualized)

8
As defined by BofA Merrill Lynch, the conversion premium is the price an
investor has to pay above the conversion value (the value of a convertible 6 Bonds
security if it were to be converted into stock) in order to own the convert-
ible security. Typically, the higher the conversion premium the less equity
4
sensitive the convertible bond is and the lower the conversion premium
the more equity sensitive. Generally, convertibles can be characterized
into the following categories: bond-like, total return/balanced, and 2
equity sensitive.
Bond-like Convertibles in this category are characterized by high 0
0 4 8 12 16 20 24
yields and high conversion premiums. Given that the equity option is
Risk (% Annualized)
so far out of the money, the security behaves almost like a pure debt
instrument with little regard given to the option value. Source: BofA Merrill Lynch; FactSet; Barclays. Stocks: S&P 500 Index, Convertibles: BofA
Merrill Lynch All US Convertibles Index, Bonds: Barclays US Aggregate Bond Index. Risk
Total Return/Balanced Convertibles in this category exhibit ideal is measured by standard deviation is an absolute measure of volatility measuring disper-
sion about an average which, for an index, depicts how widely the returns varied over a
characteristics of a convertible investment, characterized by moderate certain period of time; the greater the degree of dispersion, the greater the risk. Unless
yields/conversion premiums and a good level of equity sensitivity. otherwise noted, index returns reflect the reinvestment of income dividends and capital
gains, if any, but do not reflect fees, brokerage commissions or other expenses of invest-
ing. It is not possible to invest directly in an index.
Investor Education | Understanding convertible bonds

How have convertible bonds performed in rising interest Characteristics of the convertible bond market
rate environments? Regional Composition
During three of the four periods of rising rates since 1988, convertible As of September 2015, the global convertible bond market was valued at
bonds outperformed core bonds and treasuries. Convertible bonds USD 295 billion, of which the United States has the largest share at 63%
have historically exhibited negative to low correlations to interest-rate- followed by European Union at 24%. Meanwhile, Japan and rest of Asia
sensitive securities. represents the balance at 13%.
Convertibles have provided a cushion against rising rates
Global convertible market (%)
Rising-Rate Rising-Rate Rising-Rate Rising-Rate
Cycle 1: Cycle 2: Cycle 3: Cycle 4:
3/29/88 2/4/94 6/30/99 6/30/04
to 2/24/89 to 2/1/95 to 5/16/00 to 6/29/06 13%

Total Rate Hike 3.25% 3.00% 1.75% 4.25%


United States
Core Bonds 3.41% -2.04% 2.02% 2.99% 24% Europe
Asia (including Japan)
63%
10-Yr Treasuries 2.82% -6.07% 1.64% 2.29%

Comvertibles 11.09% -8.49% 25.43% 4.80%

Source: Morningstar Direct. Core bonds are represented by the Barclays US Aggregate
Bond Index and convertibles by the BofA Merrill Lynch All Convertibles All Qualities Index.
Core bonds, 10-year treasuries, and convertibles represent returns for the periods above.
Past performance is not a guarantee of future results. Source: BofA Merrill Lynch

How have convertible bonds performed in bull and Credit rating


bear markets? Within the US convertible market, about 46% of all outstanding issues
Convertible bonds captured more upside in bull markets than downside are not-rated (NR) securities and the majority of these NR issues (58%)
in bear markets. are large cap companies. Very often, companies forego obtaining ratings
mainly to avoid a lengthy and expensive rating process.
Market participation
January 1988 to September 2015
US Convertible Credit Ratings (%)
8
6.4 Convertibles 100
6.2
6 S&P 500 Index
90
Not rated
4 80

70
Avg. Qtrly Return (%)

2
60
0
50
Speculative grade
-2 40

30
-4
20
-6 -5.1 Investment grade
10
-8 0
-7.8
Feb-11
Apr-11
Jun-11
Aug-11
Oct-11
Dec-11
Feb-12

Feb-13

Feb-14

Feb-15
Dec-10

Apr-12
Jun-12
Aug-12
Oct-12
Dec-12

Apr-13
Jun-13
Aug-13
Oct-13
Dec-13

Apr-14
Jun-14
Aug-14
Oct-14
Dec-14

Apr-15
Jun-15
Aug-15

-10 85 Up Quarters 30 Down Quarters

Source: BofA Merrill Lynch; FactSet. Past performance is not a reliable indicator of future Source: BofA Merrill Lynch; Data as of 9/30/2015.
results. This chart is not indicative of the past or future performance of any Allianz
Global Investors product.
Note: Up and down quarters are based on quarterly performance of the BofA Merrill
Lynch All US Convertibles Index and S&P 500 Index.
Investor Education | Understanding convertible bonds

Default
Defaults in the convertible bond market have been lower than those in
the high yield market. The default rate for convertible bonds within the
US has averaged 1.0% versus 3.8% in high-yield over the period 2003 to
2014. Interestingly, not-rated securities had a lower default rate than
investment-grade and high-yield securities.

Aggregate default by ratings (2003 - 2014)


20
Non-Investment Grade
18
Investment Grade
16

14 Not Rated

12
Billions ($)

10

Source: Barclays Capital, April 2015.

Issuance Trends in the convertible bond market


Since 1990 to present, the convertible market has grown steadily. New
issuance within the US has improved over the past two years relative to
the earlier part of the decade.

Investors should consider the investment objectives, under all market conditions, and each investor should evalu- outstanding of $25 million plus. Maturities must be at least
risks, charges and expenses of any mutual fund ate their ability to invest for the long term, especially during one year. The coupon range must be equal to or greater
carefully before investing. This and other information periods of downturn in the market. Forecasts, estimates than zero and all quality of bonds are included. Preferred
is contained in the funds prospectus and summary and certain other information contained herein are based
upon proprietary research. Forecasts and estimates have equity redemption stocks are not included nor are compo-
prospectus, which may be obtained by contacting your certain inherent limitations, and are not intended to be nent bonds once they are converted into corporate stock
financial advisor or by visiting us.allianzgi.com. Please relied upon as advice or interpreted as a recommendation.
read the prospectus carefully before you invest.
Coupon rate is the interest rate stated on a bond when it is
This is for informational purposes only and does not repre- issued. Yield refers to the interest or dividends received from Mutual funds are distributed by Allianz Global Investors
sent a recommendation of any particular security, strategy a security and are usually expressed annually as a percent- Distributors LLC.
or investment product. Statements concerning financial age based on the investments cost, its current market
market trends are based on current market conditions, 2015 Allianz Global Investors Distributors LLC
value or its face value.
which will fluctuate. FL-025-1215 | AGI-2015-12-14-13925 | 01336
The Standard & Poors 500 Composite Index (S&P 500)
Unless otherwise noted, index returns reflect the reinvest- is an unmanaged index that is generally representative of
ment of income dividends and capital gains, if any, but do the US stock market. The Barclays US Aggregate Index is
not reflect fees, brokerage commissions or other expenses composed of securities from the Barclays Government/
of investing. It is not possible to invest directly in an index. Credit Bond Index, Mortgage-Backed Securities Index and
This material contains the current opinions of the author, Asset-Backed Securities Index. It is generally considered
which are subject to change without notice. Statements to be representative of the domestic, investment-grade,
concerning financial market trends are based on cur- fixed-rate, taxable bond market. The BofA Merrill Lynch All
rent market conditions, which will fluctuate. There is no Convertible All Qualities Index represents convertible securi-
guarantee that these investment strategies will work ties spanning all corporate sectors and having a par amount