The Handbook of Convertible Bonds
Modern pricing, structuring and risk management reference.
Summary
Jan De Spiegeleer and Wim Schoutens wrote this practitioner and quantitative treatment of convertible bonds, which are corporate debt instruments carrying the right to convert into the issuer's equity.
The instrument sits between markets, and the book covers all the components. It sets out the terms that define a convertible: the conversion ratio, the call and put provisions, the dividend and takeover protection clauses, and the covenants. It explains the instrument's decomposition into a bond and an embedded equity option, and why that decomposition is only approximate, since the credit quality and the equity price are correlated.
The pricing chapters cover the models used, from simple component analysis through binomial and finite difference approaches to structural models linking credit spread to equity value, and the difficulties each faces with the embedded call and the issuer's optimal call policy. The trading chapters cover convertible arbitrage, in which the investor buys the bond and shorts the underlying equity to isolate the option value, and the risks that strategy carries, including credit risk, borrow availability and the market-wide deleveraging that destroyed the strategy in 2008. The book is technical and assumes derivatives knowledge. It is a working reference rather than an introduction.
Key takeaways 7
- A convertible bond decomposes approximately into a bond and an equity option, and the approximation fails because credit and equity value are correlated.
- Issuer call provisions truncate the holder's upside and require modelling the issuer's optimal call policy rather than the holder's.
- Convertible arbitrage isolates the option value by shorting the underlying equity and depends on borrow availability and financing.
- Convertible arbitrage returns depend on realised volatility exceeding the implied volatility embedded at purchase.
- The 2008 deleveraging destroyed convertible arbitrage returns because every holder was forced to sell simultaneously.
- Structural models linking credit spread to equity price handle the correlation that component-based pricing ignores.
- Takeover and dividend protection clauses transfer specific risks back to the issuer and materially change the instrument's value.
Who should read it
Practitioners pricing or trading convertible securities who need a technical reference covering terms, models and strategy risks.
Where it sits in the reference 2
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