This paper examines the primary sources of risk embedded in convertible bonds and evaluates the extent to which diversification can address each risk type. It begins by defining convertible bonds as hybrid debt instruments and explains the role the convertible feature plays in reducing—rather than introducing—risk. The paper then distinguishes between default risk, which is difficult to diversify away, and equity risk, which can be managed through broad portfolio diversification across firms, industries, geographies, and asset classes. Drawing on Modern Portfolio Theory and the CAPM beta coefficient, the paper concludes that while most risks can be substantially reduced through diversification, default risk remains a unique and persistent challenge for convertible bond investors.
There are many sources of risk in a convertible bond, many of which can be addressed through diversification. A convertible bond is a debt instrument that can be converted into equity at certain points during its life (Investopedia, 2013). The value of a convertible bond lies primarily in the expected cash flows from its interest payments. The convertible feature is used mainly to reduce the risk of the bond. Normally, the bond is only converted to equity when the company is performing well, and in exchange for this upside potential the return is usually lower. Thus, the convertible feature reduces risk rather than introduces it. This distinction is important when analyzing the sources of risk in convertible bonds and the mechanisms available for diversifying away those risks.
The primary risk in a convertible bond resides in the bond component itself. This is default risk, and when a company is near default the convertible feature offers no meaningful protection against it. For the investor, default risk arises from problems with the company's cash flows. These problems can emerge in any number of ways — sluggish sales, poor collections policies, high fixed costs — but in every case the company is experiencing cash flow difficulties and ongoing solvency issues before default becomes a serious threat. An investor would not normally purchase a bond from a company believed to be near default, so the interest rate is the primary mechanism for compensating for default risk in a convertible bond.
This risk cannot truly be diversified away. With fixed income products, the money lost to default cannot simply be recovered through outperformance of other holdings — those other instruments will pay only what they were expected to pay, no more.
The convertible feature typically means that the bond is issued at a lower interest rate than it would carry without the conversion option. The convertible feature is therefore not a free bonus — it was paid for through the acceptance of a reduced yield. The risk can accordingly be understood as the possibility that the company's equity does not perform well enough to make exercising the convertibility option worthwhile. This is equity risk. Equity risk can be measured either with standard deviation or, more commonly, with the beta coefficient. This risk must be taken seriously, because the potential upside movement of the stock was something the investor paid for by accepting lower interest payments.
"Reviews portfolio diversification methods and asset classes"
Through diversification, most risks can be all but eliminated — and this holds true even for convertible bonds. The major exception, however, is default risk, which is not as straightforward to address. The loss associated with default is difficult to counter with other securities unless the convertible position represents a negligible portion of the total portfolio. It is therefore important to understand the degree of risk one is taking on with a convertible bond. The risk characteristics of bonds are substantially different from those of equities, and convertible bonds are not normally designed to provide protection against downside risk in cases of issuer insolvency.
Investopedia. (2013). Definition of convertible bond. Investopedia. Retrieved April 10, 2013, from http://www.investopedia.com/terms/c/convertiblebond.asp
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