Question of the week
A “convertible bond” is a debt issued by a company that can be repaid in stocks if investors so wish. The bond (debt) is therefore “convertible” into the issuing company’s stocks. A convertible bond can, for example, be repaid either for the price of 100 euros, or as five shares.
Thus, when the company’s stock rises, it pulls up with it the value of associated convertible bonds. On the other hand, if the stock falls, the parachute-effect of the convertible bond is triggered: if conversion into stocks is no longer attractive, the debt will be repaid ultimately in cash at the initial amount (except in the case of [1]default). Throughout its entire life, the bond also offers a regular coupon. A convertible bond thus behaves more and more like a stock as the stock market rises, and more and more like a bond when the market falls. This asymmetrical mechanism has the effect of slowing down bearish movements, on the condition that the bond part, or the actuarial floor, remains stable.
In the long term, convertible bonds achieve results close to those of stocks, while reducing volatility by one-third, or even by half, compared to that security class [2]. This mechanism showed its worth in February and March 2020, allowing convertible bonds to soften the fall in stocks considerably, while taking advantage of the eventual rebound [3].
[1] “Default” refers to when a borrower cannot repay its debts. Default can be partial; for example if the borrower repays only 60% of its debt and is unable to repay the remaining 40%.
[2] Over the past 10 years, from February 28, 2011 to February 28, 2021, the Thomson Reuters Global Convertible Bond Index thus had an average annualized increase of 8.2%, with a volatility of 10.2%, while the MSCI All Country World Index (stock market) saw an average annualized increase of 8.8% with a volatility of 14.1%.
[3] Past performance is not a reliable indicator of future results.
The opinion expressed above is dated 19th April 2021, and liable to change.
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