Fixed-Income Toolbox

Convertible Bond Valuation

A convertible bond (CB) is a debt instrument that can be converted into a predetermined amount of a company's equity at certain times prior to the bond's maturity.

The Fixed-Income Toolbox uses a binomial and trinomial tree approach (cbprice) to value convertible bonds. The value of a convertible bond is determined by the uncertainty of the related stock. Once the stock evolution is modeled, backwards discounting is computed.

The last column of such trees provides the data to decide which is more profitable: the debt notional (plus interest, if any) or the equivalent number of shares per the notional.

Where debt prevails, the toolbox discounts backward with the risk-free rate plus the spread reflecting the credit risk of issuer. Where stock prevails, the toolbox discounts with the risk free rate. The intrinsic value of a convertible bond is the sum of the (probability-adjusted) debt and stock portions from the last node. This is compared with current stock price, to see if voluntary or forced conversion may take place. Otherwise, its value is the intrinsic value. From here, the same discounting process is repeated after adjusting debt portion to be equal to zero if any conversion takes place. Dividends and coupons are handled discretely, at the date they occur.

The approach is equivalent to solving a one-dimensional partial differential equation such as one described by Tsiveriotis and Fernandes. (See Tsiveriotis, K. and C. Fernandes (1998), "Valuing Convertible Bonds with Credit Risk," The Journal of Fixed Income, 8 (3), 95 - 102.) Using the same example of bond specifications that they use (4% annual coupon, payable twice a year, callable after two years at 110, and redeemable at par in five years), the toolbox gives results similar to theirs.

The figure on the left shows the bond "floor" of the convertible (a 5% yield, given a 4% coupon at about 97% par) when share prices are very low.

The change of curvature located at the end of the second year is due to the activation of the embedded (soft) call feature (visible on the surface plot in the right figure).

Finally, there is the flat section when time is nearing expiration and share prices are high, indicating a delta of unity, a characteristic of in-the-money equity options embedded in a bond.

Portfolio Hedging

Treasury Bond Futures