What are the pros and cons of convertible bonds to a bond investor? Under what c

Question

What are the pros and cons of convertible bonds to a bond investor? Under what conditions would you favor buying convertibles over straight bonds? Why might you favor buying straight bonds over convertibles?

WHAT ARE YOUR THOUGHTS ON EACH RESPONSE BELOW. PLEASE ELABORATE AND EXPLAIN EACH RESPONSE TO THE ABOVE QUESTION AND YOUR OPINION. DO YOU AGREE OR DISAGREE AND WHY?

a.) Straight bonds cannot be converted into equity, convertible bonds can. If a firm is doing well and their finances are growing, it is beneficial to a bond investor to obtain convertible bonds, because once the company's value increases, the equity will be worth more than the bonds. If a company is pretty stable in growth and does not fluctuate too much, it may be better to get a straight bond. One bad thing about choosing convertible bonds is that if a company's value decreases drastically, the equity will be low and not be worth as much as the bond amount. A firm with highly fluctuating finances would also be a reason to choose straight bonds. It may be higher risk to choose convertible bonds.

b.) For a high growth company convertible bonds would be benifical over straght bonds, however if the company is a flat or not doing well then straight bonds would be the way to go. There are risks with convertible bonds, even though they can be very good investments as far as returns they have a higher risk than a straight bond.

Explanation / Answer

Convertible bond gives the investor a chance to capitalize on the bull market that is the equity upside at the same time there is protection from the bear market that is from the equity downside. If the price of the equity goes up then the investor can convert the convertible Bond to a predetermined number of shares and therefore the investor capitalizes on the equity upside whereas if the price of the equity goes downside then the investor gets the principal plus interest at the maturity and therefore a guaranteed return is there even if there is a bear market. Convertible Bonds therefore provides for capitalizing on bullish equity trends at the same time it provides hedge against market downturn.

Cons/disadvantage is that the coupon rate for the convertibles is lesser than the comparable bonds this is because there is value on equity conversion and that’s reflected in the lower yield. Normal equity market conditions would result in convertibles earning lower rate of return as compared to the comparable straight bonds. Convertibles are too much correlated with equity making them less valuable as a portfolio diversifier. There is small market for convertibles.

Under condition of high volatility of equity markets it would be worthwhile buying convertibles over straight bonds because convertibles would provide for capitalizing on the upside at the same time there is protection form the downside of the markets.

I would favor buying straight bonds over convertibles under Normal equity market conditions when there is not enough volatility so that the chances of equity gaining in value is not enough to outweigh the lesser yield earned by convertibles as compared to other flat bonds.

a) DISAGREE. As the company's value decreases drastically, the convertibles would be worth at least the straight bond. A firm with highly fluctuating finances would be a reason to choose convertibles not straight bonds because in that way we can capitalize on the upside at the same time be safe from the downside of the finances. It’s not at all higher risk to choose convertible bonds because there is a least guaranteed return in case of downside of company's value and a higher upside return in case of upside of company's value.

b) AGREE. Yes for a high growth company convertible bonds would be beneficial over straight bonds because the convertibles would capitalize on the upside on the firm's equity value whereas the straight bonds would provide the same set of returns and do not capitalize on the upside whether there is a upside in the firm's equity value or not. If the company is a flat or not doing well then straight bonds would be the best choice since the convertibles would provide lesser yield as compared to the straight bonds and therefore less preferable. Yes risks of convertibles are higher than a straight bond. The payoff of the convertibles is not fixed but depends on the equity market condition while the payoff of the straight bond is fixed and therefore less risky.

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