What is a Premium Put Convertible?
A premium convertible put is a type of bond that combines the characteristics of put obligations with the attributes of Convertible links. Like a put bond, a convertible premium put can be exchanged for cash at the discretion of the bondholder. Like a convertible bond, a convertible put premium can be converted into shares of the company at a predefined rate.
Key points to remember
- A premium convertible put is a type of bond that combines the characteristics of put bonds with the attributes of convertible bonds.
- Premium put convertibles seem to offer investors an ideal combination of limited losses and unlimited gains.
- However, premium convertibles make investors pay for their benefits in the form of lower interest rates, and their put options can be problematic.
- The attractive features of premium put convertibles can be replicated using exchange-traded funds (ETFs) and options while reducing risk.
Understanding Premium Put Convertibles
Understanding how the put function works is the first step to understanding premium put convertibles. A put option gives the owner the right, not the obligation, to sell a security at a specified price within a specified time. Like a put option on a stock, this feature includes a exercise price. The strike price is a value at which a specific derivative contract can be exercised.
The strike price of an ordinary put bond will generally be less than the issue price of the bond. However, a premium convertible put option allows an alternative arrangement where the strike price is higher with restrictions on when the put integrated can be exercised. For example, the market price of the bond or the company’s stock may need to rise above a certain level. In cases where stock and bond prices rise, the company should find it easier to repay bondholders.
The other half of understanding premium convertible bonds is learning how the convertibility line works. Convertibility allows the bondholder to convert the bond into an agreed number of shares of the underlying stock. The ratio at which the bond trades for equity is the conversion rate. The conversion ratio is determined at the time of issue and impacts the relative price of the security. The conversion does not involve any exchange of cash or funds, only shares of the underlying asset.
Premium put convertibles can only be converted on a single day. However, rolling put convertibles can be converted on more than one date.
Advantages of Premium Put convertibles
Premium put convertibles seem to offer investors an ideal combination of limited losses and unlimited gains. Theoretically, the sell feature can protect investors if the issuing company does poorly. If the issuer does well, the convertible feature allows premium put convertible bonds to be exchanged for shares of the company.
Disadvantages of Premium Put convertibles
The first drawback of premium convertibles is their low interest rates. Obviously, having protection in the form of a put option and the potential for higher returns due to stock convertibility are desirable features. These features come at a cost, and that cost usually comes in the form of lower interest rates.
The second issue is building the sales functionality. A typical put bond has the strike price set below the bond’s issue price, and it can be exercised to limit any losses that might arise. The story is different for a premium convertible put with restrictions requiring the market price of the bond to reach a higher strike price before it can be exercised. If the company does poorly, the bond price might never reach the strike price. In this case, the put option offers no protection because it cannot be exercised.
Finally, the attractive features of premium put convertibles can be duplicated by using exchange traded funds (ETFs) and options while reducing risk. For example, an investor can buy a bond ETF, buy a put option to limit downside potential, and buy a call option on a stock market ETF. Like premium put convertibles, such an arrangement reduces maximum losses and allows for more gains, but it also benefits from more diversification.
Buying call and put options directly gives investors far more control over their risks and rewards than the options embedded in premium put convertible bonds.
Example of a Premium Put convertible bond
Consider an investor who holds a premium convertible bond with a face value of $1,000, a coupon rate of 4%, and a put option at a strike price of $1,200. Suppose the put function also has a restriction requiring the market price to reach the strike price before it can be exercised. Finally, each bond can be converted into 10 shares of the underlying stock of XYZ Company.
One year from maturity, the bond reaches its strike price of $1,200. The investor can then exercise the put option and resell the bond to the issuer at $1,200. Alternatively, the bondholder can convert the bond into 100 XYZ shares. If XYZ’s stock price exceeds $120 per share, this would be an attractive option.