The basic premise behind a convertible bond is to combine a bond with a call option, providing an investor the chance to participate in potential equity appreciation, while mitigating downside participation with bond-like characteristics, specifically, a periodic coupon and principal repayment at maturity.

Why companies issue convertible bond?

1. When a company is young or otherwise having limited access to public equity market. For many tech or health care firms, they are startups or newer firms without sufficient track record and are thus perceived as risky business. For these firms, convertible bond is often their cheapest option for capital raising, as they may experience high interest expenses when issuing debts (often non-IG) through traditional bonds. Besides, due to the embedded call option on the underlying equity, their relatively high risks (underlying equity volatility) make their convertibles bonds more valuable. This explains that why technology firms account for roughly 35% weights of the BofA Convertible bond index, as the high vol nature of technology sector benefit more from the optionality (compared with the utility sector) and the down-side protection through bond-floor matters more for these high-risk names.
2. When the equity price is depressed, firms do not want to issue equity at a low price and dilute the existing shareholders. By issuing convertibles, company gains access to capital while delaying the dilution to a later date, when the equity market is at a higher price at which the conversion may takes place. They so can gain access to the same amount of capital through issuance of less shares.
3. As an alternative to raising a straight bond, the issuer is ale to pay a lower coupon than a bond since the conversion option is valuable to the investor.

Why we should invest in convertible bonds?

1. An all-weather asset class, combining bond and equity features
   • Upside participation: Access to a long-term call option, benefiting from equity upside potential
   • Downside protection: The benefits of a bond-floor, to mitigate equity volatility and downside risk
   • As a result, convertibles tend to shine during medium to high volatility periods[1].
2. Guard against rising rates: Convertible bonds perform well during rising rates environment.
   • Convertible universe is a blend of IG and HY issuers. It exhibits high correlation to small and mid-cap equities, low correlation to IG credit, and negative correlation to US treasury bonds.
   • Rates are rising usually during economic expansion period. In a growing economy, many companies may generate more profits with improved financial performance, stable issuer fundamentals and as such, experience stock price appreciation during increasing treasury yields. Stocks tend to outperform bond during these periods. Since a convertible bond’s price is positively influenced by the underlying stock price, their prices are less influenced by changes in interest rates than other fixed income securities. Convertible bonds performed well during several rising rates periods, such as 98-00, 04-06, 09-10, 12-13, etc. It also outperformed equities and bonds during rising rate shocks such as ‘taper tantrum’ in 2013[2].
   • As a result, it has significantly reduced interest rate sensitivity
3. Diversification benefits and broader opportunity sets
   • In addition to low correlation to IG bonds and US treasuries, convertibles provide diversification with respect to equities and HY issuers. 82% of non-IG convertible issuers are not represented in the HY universe.
   • On a sector basis, the convertible market is heavily weighted towards technology, financials and health care.
4. Convertible bonds provide high risk-adjusted returns: for a given level of risk, convertible generated greater returns than equities historically.

 

Reference

[1] https://mainstayinvestmentsblog.com/2018/05/convertibles-shine-through-clouds-of-volatility/

[2] https://www.blackrockblog.com/2018/01/18/case-for-convertibles/