Convertible Bonds: Funding Strategies, Pricing, Liquidity and Market Observations
Convertible bonds are securities that can be converted into common stock at the option of the investor. As corporate debt instruments they give the holder the right to forgo future principle and/or coupon payments to convert such payments into a predefined quantity of shares in a company's stock. Convertible bonds give the holder the ability to share in the price appreciation of a company's stock with the safety of a floor price set at the debt level. The presence of downside protection makes convertibles attractive to many private and institutional investors searching for yield-enhancing securities with a degree of defense against adverse volatility movements. As a hybrid security, convertibles are generally priced as a straight bond and a call option on the underlying equity. This chapter will discuss traditional and contemporary valuation techniques aligned to the accounting treatment of convertible bonds. It will also analyze the optimal call and conversion policy of issuers and investors respectively, with reference to recovery rate, hazard rate, coupon payments and dividend yield of the security. Our analysis will then show that the likelihood of convertible debt issues increases when the costs of either straight debt or common stock issues are high, and mirrors the 'backdoor equity hypothesis' which predicts that convertible bonds are a substitute for common equity and that this substitution is most likely to occur in firms facing significant information asymmetries and high financial distress costs. Using stock liquidity analysis, we will see that the probability of exercise of convertible bonds issued against a firm's stock directly affects the liquidity of the stock itself, while controlling for firm size, book to market equity value and firm beta. The effects of conversion probability on stock liquidity are less pronounced for smaller firms, which helps explain time series variations in the liquidity premiums for smaller firms over time.
Economics of Debt