Convertible Bonds

This is a historical learning note and may contain outdated or incomplete understanding.

Note: The original VNote structure and historical views are preserved. Product rules, returns, policies, and specific assets are time-sensitive; only clear errors or changed institutional rules are corrected minimally. This is not investment advice.

1. What It Is

A corporate bond that can be converted into stock.
- Why does a company issue bonds? To raise financing, with money to be repaid later.
- A convertible bond can instead be converted into shares under its terms.

2. Why Convertible Bonds Are Needed

2.1. Company

For a company, equity financing avoids repayment of principal, while bond financing creates a repayment obligation. Equity issuance and bond issuance are subject to different conditions. A convertible bond gives the company a possible path from debt to equity if conversion occurs.

2.2. Investor

For investors, the original note describes the appeal as having a bond-like downside component and equity-linked upside, while the instrument can trade at a premium and remains exposed to issuer and market risk.

2.2.1. Bond-Like Floor

Convertible bonds pay interest under their terms.

2.2.2. Equity-Linked Upside

Stock price rises
- Suppose bond A has a conversion price of 10 yuan/share and the stock price is 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, those 10 shares are worth 10 * 20 = 200 yuan.
Stock price falls
- Suppose bond A has a conversion price of 10 yuan/share and a face value of 100 yuan, giving 100/10 = 10 shares at conversion.
- If the stock falls to 6 yuan/share, the company may, subject to the bond terms and procedures, lower the conversion price. If it becomes 5 yuan/share, a 100-yuan face-value bond converts into 100/5 = 20 shares, worth 20 * 6 = 120 yuan at that stock price.

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 coupon rate shown in the figure and discounted using an appropriate bond yield. ChinaBond Yield Data

3.1.2. Equity Characteristic

Suppose face value is 100 yuan, the bond trades at 121 yuan, conversion price is 10 yuan/share, and the stock trades at 11 yuan/share. Conversion value = 100/10 * 11 = 110 yuan, so the conversion premium is (121 - 110) / 110 = 10%. The premium comes from the bond’s embedded-option characteristics.

3.2. Rights

3.2.1. Forced Redemption

A right of the listed company under specified terms. If the stock rises enough and the contractual trigger is met, the company may announce forced redemption. Holders may then prefer converting into stock rather than being redeemed, turning debt into equity.

3.2.2. Downward Revision

A right available to the listed company under the bond’s terms and procedures. When the stock falls sufficiently, the company may propose lowering the conversion price, which can make conversion more attractive.

3.2.3. Put-Back Right

An investor right under specified contractual conditions. If the underlying stock performs poorly or specified use-of-proceeds conditions change, holders may under the applicable terms have a right to sell the convertible bond back to the listed company at the contractual price.

4. How to Invest

4.1. IPO Subscription

The original note suggests looking at averages and treating values above 110 as a sign of favorable conditions.

4.2. “Double-Low” Strategy

Build a coordinate system with convertible-bond price on the x-axis and conversion premium on the y-axis, dividing convertible bonds into four quadrants:

Quadrant 1: high price, high premium. The note describes these as often higher-quality issues with stronger forced-redemption expectations and leading underlying companies.
Quadrant 2: low price, high premium. Often low conversion value, stronger bond characteristics and weaker equity characteristics, with less sensitivity to the stock market.
Quadrant 3: low price, low premium. Stronger bond characteristics without weak equity characteristics; the note views these as defensive/offensive candidates.
Quadrant 4: high price, low premium. Weaker bond characteristics and stronger equity characteristics.

The note’s formula is: return = 100 / conversion price * stock price - bond price. It therefore favors lower bond prices and a higher stock-price/conversion-price ratio.

Downside protection: the original note said “buy convertible bonds below face value.” Trading below face value does not guarantee principal protection; issuer credit, default/delisting, contractual changes, and liquidity risk still matter.

Offense: convertible bonds with an absolute price below 110 yuan and a conversion premium below 20%, according to the historical rule recorded in the note.

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

Select convertible bonds within their put-back period.
Select issues that have not already revised downward this year after meeting revision conditions.
Select ratings above AA.
Select issues with positive after-tax yield to maturity.