Convertible Bonds

This is a historical learning note and may contain outdated or incomplete understanding.

1. What It Is

A type of corporate bond that can be converted into stock.
- Why do companies issue bonds? To raise financing, and the money needs to be repaid after a period of time.
- A convertible bond can instead be repaid with shares rather than cash; that is, it is a bond that can be converted into stock.

2. Why Convertible Bonds Are Needed

2.1. Companies

For a company, stock issuance is preferable to bond issuance for financing because bonds need to be repaid. However, the conditions for issuing stock are stricter than those for issuing bonds, so companies more often issue bonds. Convertible bonds allow a company to repay with stock instead of cash, and convertible bonds are priced more expensively than traditional bonds, so companies may prefer issuing convertible bonds to traditional corporate bonds.

2.2. Investors

For investors, the advantage can be summarized as “a downside floor and uncapped upside,” while the disadvantage is that the price is higher than stocks and pure bonds. The “floor” is not risk-free; credit, liquidity, and clause risks still apply.

2.2.1. Downside Floor

Convertible bonds pay interest.

2.2.2. Uncapped Upside

Stock rises
- Suppose bond A has a conversion price of 10 yuan/share, while stock A currently trades at 10 yuan/share. A bond with face value 100 yuan can be converted into 100/10 = 10 shares.
- If the stock rises to 20 yuan, the 10 shares are worth 10 * 20 = 200 yuan, producing a profit.
Stock falls
- Suppose bond A has a conversion price of 10 yuan/share, while stock A currently trades at 10 yuan/share. A bond with face value 100 yuan can be converted into 100/10 = 10 shares.
- If the stock falls to 6 yuan/share, the company may issue a revision notice and lower the conversion price to 5 yuan/share. A 100-yuan face-value bond can then be converted into 100/5 = 20 shares, worth 20 * 6 = 120 yuan in total.

3. Convertible-Bond Characteristics

3.1. Bond and Equity Characteristics

3.1.1. Bond Characteristic

With a face value of 100, future cash flows can be calculated from the interest rate and then discounted to present value using a discount rate from ChinaBond Yield.

3.1.2. Equity Characteristic

Suppose the bond has a face value of 100 yuan, the bond price is 121 yuan, the conversion price is 10 yuan/share, and the actual stock price is 11 yuan/share. The conversion value is 100/10*11 = 110 yuan, so the premium rate is (121-110)/110 = 10%. The premium arises from the option characteristics of a convertible bond.

3.2. Rights

3.2.1. Forced Redemption

A right of the listed company. If the stock rises too much, the company can issue a forced-redemption notice and redeem the convertible bond. Holders will then tend to convert into shares rather than be redeemed, turning bonds into shares so the company does not have to repay the bond in cash.

3.2.2. Downward Revision

A right of the listed company. If the stock falls too much, the company can issue a revision notice and lower the conversion price. Holders will then tend to convert into shares rather than continue holding the bond, turning bonds into shares so the company does not have to repay the bond in cash.

3.2.3. Put

A right of the investor. We buy convertible bonds in the hope that the stock will rise later, the bonds will be converted into shares, and those shares can then be sold at a high price. But if the company’s stock keeps falling, under certain conditions (within the put period && the underlying stock price is below 70% of the conversion price for 30 consecutive trading days || the actual use of the funds borrowed by the listed company changes substantially), the convertible bond can be sold back to the listed company at a specified price (face value + current-period interest).

4. How to Invest

4.1. New-Issue Subscription

Calculate the average; if it is above 110, treat the market as relatively good.

4.2. Double-Low Strategy

Build a coordinate system with the convertible-bond price on the horizontal axis and the conversion premium rate on the vertical axis, and divide all convertible bonds into four quadrants. Quadrant 1: high price, high premium. These convertible bonds are generally considered higher quality, with a high certainty of forced redemption, and the corresponding companies are industry leaders. Quadrant 2: low price, high premium. These convertible bonds often have low conversion value, stronger bond characteristics and weaker equity characteristics, and are less affected by the broad market. Quadrant 3: low price, low premium. These convertible bonds have strong bond characteristics without weak equity characteristics and are described as a defensive-and-counterattack type. Quadrant 4: high price, low premium. These convertible bonds have weak bond characteristics and strong equity characteristics. Any investment follows the idea of buying low and selling high. return = 100 / conversion price * underlying stock price - bond price; under this expression, a lower bond price and a higher underlying-stock-price/conversion-price ratio are preferable. Floor: buy convertible bonds below the face value of 100 yuan, but trading below face value does not mean the investment is risk-free. Attack: convertible bonds with an absolute price below 110 yuan and a conversion premium rate below 20%.

4.3. Buy Convertible Bonds That May Revise the Conversion Price Downward

Select convertible bonds within the put period; Select convertible bonds that have not already revised downward this year after meeting the downward-revision conditions; Select convertible bonds rated above AA; Select convertible bonds with a positive after-tax yield to maturity;