[1] It originated in the mid-19th century, and was used by early speculators such as Jacob Little and Daniel Drew to counter market cornering.
[2] Convertible bonds are most often issued by companies with a low credit rating and high growth potential.
The investor receives the potential upside of conversion into equity while protecting downside with cash flow from the coupon payments and the return of principal upon maturity.
From the issuer's perspective, the key benefit of raising money by selling convertible bonds is a reduced cash interest payment.
[4] It is a hybrid investment vehicle, which carries the (limited) protection of debt at the start, but shares in the upside as equity if the startup is successful, while avoiding the necessity of valuing the company at too early a stage.
They may offer coupon regular payments during the life of the security and have a fixed maturity date where the nominal value of the bond is redeemable by the holder.
This type is the most common convertible type and is typically providing the asymmetric returns profile and positive convexity often wrongly associated to the entire asset class: at maturity the holder would indeed either convert into shares or request the redemption at par depending on whether or not the stock price is above the conversion price.
Those securities would very often bear two conversion prices, making their profiles similar to a "risk reversal" option strategy.
They would for instance miss the modified duration mitigation effect usual with plain vanilla convertibles structures.
This distinction is usually made in terms of risk i.e. equity and credit risk being correlated: in some cases the entities would be legally distinct, but not considered as exchangeable as the ultimate guarantor being the same as the underlying stock company (e.g. typical in the case of the Sukuk, Islamic convertible bonds, needing a specific legal setup to be compliant with the Islamic law).
Synthetics are more similar to structured products with settlement done in cash and no equities being produced as the result of a conversion.
The Packaged Convertibles (e.g. Siemens 17 DE000A1G0WA1) are sometimes confused with synthetics due to the fact an issuer (sometime a portfolio manager) will create a structure using straight bonds and options.
Where there are issuer calls and investor puts, these will affect the expected residual period of optionality, at different share price levels.
The binomial value is a weighted expected value, (1) taking readings from all the different nodes of a lattice expanding out from current prices and (2) taking account of varying periods of expected residual optionality at different share price levels.
Investors should have a keen awareness of significant credit risk and price swing behavior associated with convertible bonds.
Consequently, valuation models need to capture credit risk and handle potential price jumps.
Even if the fixed market turns, it may still be possible for a company to borrow via a convertible carrying a lower coupon than ever would have been possible with straight debt funding.
Subordination of convertible debt is often regarded as an acceptable risk by investors if the conversion rights are attractive by way of compensation.
For countries, such as the UK, where companies are subject to limits on the number of shares that can be offered to non-shareholders non-pre-emptively, convertibles can raise more money than via equity issues.
Under the UK's 1989 Guidelines issued by the Investor Protection Committees (IPCs) of the Association of British Insurers (ABI) and the National Association of Pension Fund Managers (NAPF), the IPCs will advise their members not to object to non pre-emptive issues which add no more than 5pct to historic non-diluted balance sheet equity in the period from AGM to AGM, and no more than 7.5pct in total over a period of 3 financial years.
There is no attempt to assign probabilities of conversion in both circumstances, which would result in bigger convertible issues being permitted.
The reason for this inconsistency may lie in the fact that the Pre Emption Guidelines were drawn up in 1989, and binomial evaluations were not commonplace amongst professional investors until 1991–92.