Convertible Bonds: 3-in-1 product

When equity markets fall down, investors are looking to alternatives and naturally come to Convertible Bonds (CBs). What else could provide them with the equity synthetic behavior when price increase, while giving them the capital protection when price decrease? In the fastest growth economy region of the world, CBs will be at the heart of the Asian-Pacific trading activities.

But let's start from the beginning with a reminder of what CBs are: 3-in-1 product, combining Equity, Yield and Hybrid instruments. CBs are corporate bonds that can be exchanged for a predefined number of shares at maturity. Such as, a holder of CB will receive an interest coupon until the maturity when he will have the choice either to get back the par value of the bond or to convert the bond into a certain number of shares corresponding to the conversion ratio or premium. In other words, we have a combination of a Bond and a Call option.

Depending of the price of the equity, the CB will have 3 different behaviors:

• Out-of-the-money: Yield instrument
  As the conversion price is higher than the equity price, the CB is like a standard bond, with a low sensitivity to the equity price, and a high dependency to the interest rates and issuer credit spread.
• In-the-money: Equity
  As the conversion price is lower than the equity price, the CB is like a share, with a high sensitivity to the equity price, and very small impacts from interest rates or issuer credit spreads.
• At-the-money: Hybrid instrument
  As the conversion price is similar to the equity price, the CB is sensitive to the equity price and its volatility, as well as to the interest change and the issuer credit spreads.

We understand then why the interest of such products is constantly increasing, targeting investors who are willing to participate to the growth of the equity market if it will recover strongly with a safety position of positive yield if not.

Upside of 25 percent from here would be a conservative estimate and it could be as much as 50 percent

Predictions are very optimistic and even a conservative estimation will forecast gains of 25% to 50% as mention the Citigroup Inc's head of Convertible Bonds trading in Asia, Kim Wong. Although CB overall have lost 1.48% this year after gaining 36.3% in 2009, we are far from the 11.45% fall of the MSCI World Index of stocks. Asian convertibles are more attractive than those of Europe and the US, because of the relative economic strength that should come up with a faster equity market recovery. The size of Asia's CB market means volatility is higher than other parts of the world.

Let's keep an eye on this growing market and make sure we would accompany the settlement of CB activity in Asia