Debunking the complexity of Converts

March 29, 2021

1:42 pm

Convertible bonds are less complex than you might think.

We understand why some believe the asset class to be the domain of specialists, but perhaps if we address three of the subjects that present a challenge for investors, convertible bonds will seem much more straightforward to understand. These three topics are:

  • Convertible bond valuation
  • Whether convertibles behave more like stocks or bonds
  • Liquidity profile of convertibles and the overall convertible bond market

Yes, there is some math involved. But there are no calculations required if you read further!

Convertible bonds are a corporate bond with an embedded option to convert into shares. This requires work on a fundamental level to have a view on:

  1. The value of the underlying stock
  2. The credit spread of the issuer

These two aspects of valuation should be familiar for most investors, even if the work to do so isn’t necessarily easy.

On the other hand, valuing equity options, might seem like a daunting topic to comprehend. The reason why the creators of the Black-Scholes option pricing formula received a Nobel Prize is that they were able to adapt a model from physics that required only five inputs to price an option:

  1. Time until maturity
  2. The current price of the stock, plus dividend yield (if applicable)
  3. The strike (or conversion) price
  4. A risk-free rate
  5. A forecast annualised volatility for the underlying stock

The sensitivity of the conversion option to these inputs varies, but probably the most important to understand is volatility. This is a standardised measure that shows the potential range of outcomes around a central (mean) value, which is used to determine the probability that the underlying stock might reach the strike price within the life of the option. The higher the volatility, the greater the probability the stock can reach the strike price, which increases the value of the option.

Also, investors can take the value of the option on its own, which one can do for a convertible bond by first valuing the bond component, and solve for its volatility using the current market price. A cheap option would be where the “implied” volatility backed out of the market price is lower than the estimate for future or the actual realised volatility on the stock, or for listed options.

Finally, if we can solve for option values for an individual convertible bond, we can also do so for the entire convertible market. One thing to note is that when we see new issuance in our market, the levels of secondary market valuation are an influence on how a new deal is priced.

A question we often receive relates to what drives this option-implied level of valuation. Much like a stock or bond, there are fundamental estimates of value (in this case, a volatility forecast) but also different opinions and levels of demand in the market. Some investors prefer one convertible bond to another and are willing to pay up to hold a position. Yet cheap—in the context of option-implied valuation, doesn’t always mean unloved or unwanted. What we know as convertible bond investors is that markets that trade cheaply also tend to offer better convexity, where the expected upside is greater than the expected downside for an equal move in the underlying stock.


In its simplest form, the answer depends mostly on the price of the underlying stock compared with the strike/conversion price of the option itself.

There are three states that we can review for an individual convertible bond:

  • Out-of-the money (more bond-like)
  • At-the-money (“balanced” or hybrid characteristics)
  • In-the-money (more equity-like)

Our preference as directional, long-only investors is for the second type of convertible. They offer the most convexity, meaning a positive ratio of upside participation versus downside risk for an equal move up or down in the underlying stock. Our portfolios are structured to give this balanced profile so that investors get equity-like returns along with bond-like protection.

The first type behaves more like a bond simply because the underlying stock price is very far away from the conversion price. As a result, small moves in the underlying stock won’t affect the price of the convertible, given that the option is a very small component of the overall price. Or, to put it another way, the convertible is trading on its bond floor, with limited equity sensitivity. This type of convertible is also more sensitive to factors affecting bonds, such as duration and credit.

The second type of convertible is trading above its bond floor, but not too far away. The reason why these bonds have convexity is that the convertible should be protected on the downside by reaching its bond floor value, while for a move up in the underlying stock, the conversion option will gain in value, although not initially at the same rate as the stock is moving upwards.

Finally, the third type of convertible is trading well above its bond floor, with an almost full participation to moves in the underlying stock that drives most of the changes to the convertible bond’s price. While this sounds attractive for stocks that continue to trade higher, a sharp move to the downside would cause the convertible to fall in-line with the stock, with the bond floor a long way further down.


We very much understand the reasons why investors want to understand the liquidity available in our market. After all, convertibles are a smaller subset of the broader corporate bond markets. And while it has been a decade since the 2008-2009 period, it is true that convertibles were affected badly at that time from the forced deleveraging of hedge fund strategies.

Let’s look first at the size of our market and note some of the trends that we have witnessed for issuance of convertible bonds.

2020 saw the highest amount of primary issuance of convertible bonds in more than a decade. This marked a big departure from quiet conditions for convertibles during the 2010s, where low interest rates and low volatility led many issuers to the straight debt markets instead. According to Refinitiv, the global convertible market was less than $400bn in size as of 2016. But with the return of volatility and the unprecedented conditions forced by the coronavirus pandemic, our market has grown past $670bn in size as of March 2021. We have found that growth of the market has been helpful for liquidity, with more bonds to trade and a broadening of sector representation.

Let us turn now to what happens once investors such as ourselves buy a new bond for our portfolios. We are commonly asked at what point we would sell a convertible, whether we ever intend to convert, or what happens if the underlying stock falls in price.

The answer is that there are more than a few preferred habitats for different types of investors that use our market, and that helps us with liquidity. By contrast, while it is true that broad equity and credit markets can see inflows or outflows based on asset allocation decisions, there are separate groups of investors managing either stock or bond portfolios only. Rarely will an equity investor sell stock to a bond fund, or a credit investor buy stock in significant size for their portfolios.

Below are some examples using the three types of convertible that we have mentioned:

We tend to see more crossover investors from fixed-income markets with interest in out-of-the money convertibles. This group of investors allows us to sell positions that have limited equity optionality, particularly if they are positive-yielding or offer value in credit versus the issuer’s other straight bonds. Also, it is often the case that a convertible with an out-of-the-money conversion option has kept its credit strength, even if the underlying stock price has fallen. That means even investment grade investors can buy convertibles that have out-of-the-money options. We do see instances of stressed or distressed convertibles, which have their own specialist investor bases, but our hope is that we have exited these positions long before credit become a problem.

For at-the-money convertible bonds, the main base of holders tends to be dedicated convertible investors, or market-makers looking to facilitate trades. We find that there are enough differences of investment opinion to make for an active secondary market. Also, there have been few passive strategies or vehicles launched to date; flows in and out of these funds have affected liquidity for other markets. In fact, flows often happen within our market, where one convertible-focused fund is looking to invest inflows that are a result of disinvesting from another investor, who then needs to sell. We have found that the flows among long-only convertible investors have been absorbed in an orderly manner, for the most part.

When an underlying stock performs very well, making the convertible an in-the-money option, these more equity-like convertibles become more appealing to relative value investors. This set of buyers includes both hedge funds and market-makers, who want to extract options from the convertible that they believe will become more valuable with volatility. If our market was composed of mainly long-only investors, it would be a potential struggle to sell out of winners, should no other investor want to hold an equity-like convertible with low convexity. But the presence of relative value investors allows long-only investors to sell out of winners and redeploy into more at-the-money convertibles, which tend to have more convexity and better suit directional investment strategies.

Finally, let’s re-examine what caused the forced sell-off of convertibles in 2008-2009 and estimate the likelihood of these conditions returning.

At their peak, hedge funds and other leveraged investors (including proprietary trading arms of banks) were holding roughly 75% of bonds in the convertible market. Then, banks came under stress and needed their prime brokerage divisions to call back credit that had been extended to these leveraged strategies. As a result, the unwind of the leverage needed to sustain these relative value positions meant that most investors in convertibles were forced to sell, but there were few natural buyers on the other side of their trade.

What changed in 2009 was that long-only, unleveraged convertible investors became the main holders of convertible bonds. After the forced selling of levered convertible strategies, the convertible market cheapened massively, and new allocations came instead to long-only strategies, which got the existing benefits of convexity along with an extra discount. We see this trend as here to stay. In many ways, we see a useful symbiosis between the stability that comes from allocations to long-only strategies, while still allowing for opportunities for relative value investors.

No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment.
In case you missed it…

The term “RWC” may include any one or more RWC branded entities including RWC Partners Limited and RWC Asset Management LLP, each of which is authorised and regulated by the UK Financial Conduct Authority and, in the case of RWC Asset Management LLP, the US Securities and Exchange Commission; RWC Asset Advisors (US) LLC, which is registered with the US Securities and Exchange Commission; and RWC Singapore (Pte) Limited, which is licensed as a Licensed Fund Management Company by the Monetary Authority of Singapore.

RWC may act as investment manager or adviser, or otherwise provide services, to more than one product pursuing a similar investment strategy or focus to the product detailed in this document. RWC seeks to minimise any conflicts of interest, and endeavours to act at all times in accordance with its legal and regulatory obligations as well as its own policies and codes of conduct.

This document is directed only at professional, institutional, wholesale or qualified investors. The services provided by RWC are available only to such persons. It is not intended for distribution to and should not be relied on by any person who would qualify as a retail or individual investor in any jurisdiction or for distribution to, or use by, any person or entity in any jurisdiction where such distribution or use would be contrary to local law or regulation.

This document has been prepared for general information purposes only and has not been delivered for registration in any jurisdiction nor has its content been reviewed or approved by any regulatory authority in any jurisdiction. The information contained herein does not constitute: (i) a binding legal agreement; (ii) legal, regulatory, tax, accounting or other advice; (iii) an offer, recommendation or solicitation to buy or sell shares in any fund, security, commodity, financial instrument or derivative linked to, or otherwise included in a portfolio managed or advised by RWC; or (iv) an offer to enter into any other transaction whatsoever (each a “Transaction”). No representations and/or warranties are made that the information contained herein is either up to date and/or accurate and is not intended to be used or relied upon by any counterparty, investor or any other third party.

RWC uses information from third party vendors, such as statistical and other data, that it believes to be reliable. However, the accuracy of this data, which may be used to calculate results or otherwise compile data that finds its way over time into RWC research data stored on its systems, is not guaranteed. If such information is not accurate, some of the conclusions reached or statements made may be adversely affected. RWC bears no responsibility for your investment research and/or investment decisions and you should consult your own lawyer, accountant, tax adviser or other professional adviser before entering into any Transaction. Any opinion expressed herein, which may be subjective in nature, may not be shared by all directors, officers, employees, or representatives of RWC and may be subject to change without notice. RWC is not liable for any decisions made or actions or inactions taken by you or others based on the contents of this document and neither RWC nor any of its directors, officers, employees, or representatives (including affiliates) accepts any liability whatsoever for any errors and/or omissions or for any direct, indirect, special, incidental, or consequential loss, damages, or expenses of any kind howsoever arising from the use of, or reliance on, any information contained herein.

Information contained in this document should not be viewed as indicative of future results. Past performance of any Transaction is not indicative of future results. The value of investments can go down as well as up. Certain assumptions and forward looking statements may have been made either for modelling purposes, to simplify the presentation and/or calculation of any projections or estimates contained herein and RWC does not represent that that any such assumptions or statements will reflect actual future events or that all assumptions have been considered or stated. Forward-looking statements are inherently uncertain, and changing factors such as those affecting the markets generally, or those affecting particular industries or issuers, may cause results to differ from those discussed. Accordingly, there can be no assurance that estimated returns or projections will be realised or that actual returns or performance results will not materially differ from those estimated herein. Some of the information contained in this document may be aggregated data of Transactions executed by RWC that has been compiled so as not to identify the underlying Transactions of any particular customer.

The information transmitted is intended only for the person or entity to which it has been given and may contain confidential and/or privileged material. In accepting receipt of the information transmitted you agree that you and/or your affiliates, partners, directors, officers and employees, as applicable, will keep all information strictly confidential. Any review, retransmission, dissemination or other use of, or taking of any action in reliance upon, this information is prohibited. The information contained herein is confidential and is intended for the exclusive use of the intended recipient(s) to which this document has been provided. Any distribution or reproduction of this document is not authorised and is prohibited without the express written consent of RWC or any of its affiliates.

Changes in rates of exchange may cause the value of such investments to fluctuate. An investor may not be able to get back the amount invested and the loss on realisation may be very high and could result in a substantial or complete loss of the investment. In addition, an investor who realises their investment in a RWC-managed fund after a short period may not realise the amount originally invested as a result of charges made on the issue and/or redemption of such investment. The value of such interests for the purposes of purchases may differ from their value for the purpose of redemptions. No representations or warranties of any kind are intended or should be inferred with respect to the economic return from, or the tax consequences of, an investment in a RWC-managed fund. Current tax levels and reliefs may change. Depending on individual circumstances, this may affect investment returns. Nothing in this document constitutes advice on the merits of buying or selling a particular investment. This document expresses no views as to the suitability or appropriateness of the fund or any other investments described herein to the individual circumstances of any recipient.

AIFMD and Distribution in the European Economic Area (“EEA”)

The Alternative Fund Managers Directive (Directive 2011/61/EU) (“AIFMD”) is a regulatory regime which came into full effect in the EEA on 22 July 2014. RWC Asset Management LLP is an Alternative Investment Fund Manager (an “AIFM”) to certain funds managed by it (each an “AIF”). The AIFM is required to make available to investors certain prescribed information prior to their investment in an AIF. The majority of the prescribed information is contained in the latest Offering Document of the AIF. The remainder of the prescribed information is contained in the relevant AIF’s annual report and accounts. All of the information is provided in accordance with the AIFMD.

In relation to each member state of the EEA (each a “Member State”), this document may only be distributed and shares in a RWC fund (“Shares”) may only be offered and placed to the extent that (a) the relevant RWC fund is permitted to be marketed to professional investors in accordance with the AIFMD (as implemented into the local law/regulation of the relevant Member State); or (b) this document may otherwise be lawfully distributed and the Shares may lawfully offered or placed in that Member State (including at the initiative of the investor).

Information Required for Distribution of Foreign Collective Investment Schemes to Qualified Investors in Switzerland

The representative and paying agent of the RWC-managed funds in Switzerland (the “Representative in Switzerland”) is Société Générale, Paris, Zurich Branch, Talacker 50,

P.O. Box 5070, CH-8021 Zurich. In respect of the units of the RWC-managed funds distributed in Switzerland, the place of performance and jurisdiction is at the registered office of the Representative in Switzerland.

Ready to start talking?