Explain why the factors mentioned in the quote affect the value of a convertible bond and why the factors interact

Question

What will be an ideal response?

Answer 1

First, convertibles have equity options. The convertible can be converted at a profit into equity if the price of equity rises above the conversion price. The probability of converting increases as the volatility increases. As debt, a convertible issue can fall in value as interest rates increase. This is because bond prices are inversely related to changes in interest rates. Spread volatility means there is uncertainty in reinvesting either interest payments or principal received. As spreads decrease the profit above what one would receive on a comparable Treasury deceases.

These factors interact. For example, stock prices tend to fall as interest rates increase. This is because corporate profits decline as costs of borrowing go up. The end result is that the value of convertibles will fall in value due to a decrease in upside potential. An increase in the volatility of the spread is a sign of uncertainty in the economic climate associated with negative prospects for companies. This will lead to lower stock prices and thus the value of convertibles decline due to a decrease in upside potential.

The straight value of a convertible can change for a variety of interrelated reasons. For example, if interest rates rise in the economy, the straight value will decline. Even if interest rates do not rise, the perceived credit worthiness of the issuer may deteriorate, causing investors to demand
a higher yield from an increase in spreads. In fact, the stock price and the yield required by investors are not independent. When the price of the stock drops precipitously, the perceived credit worthiness of the issuer may decline, causing a decline in the straight value. In any event, although the straight value may decline, it still is a floor (albeit a moving floor) for the convertible bond price.