convertible bond arbitrage

Hello everyone.

One of the concerns of convertible bonds is the credit issue: Credit issues may complicate valuation since bonds have exposure to credit risk. When credit spreads widen or narrow, there would be a mismatch in the values of the stock and convertible bond positions that the convertible manager may or may not have attempted to hedge away.

Does this refer to the fact that when spreads widen (narrow), then the bond value goes (down)/(up), so you get potential mismatches in value upon conversion of the bond into shares? Or how does credit risk impact a convertible bond?

Thanks a lot!

Conversion is a ratio( you know it from level 2).

  1. If stocks appreciate in nature INDEPENDENT of Bond price movement, the conversion pays off because it acts like a warrant.

  2. If there is a credit movement in the bond, the stock will definitely be impacted ( the stocks seats beneath bond in the capital structure) and more often than not, the movement is proportional ( not necessarily symmetrical) Impaired credit movement of the bond will mean the stock will definitely suffer. However, if the rating notches upward or the credit spread narrows, the stock may or may not appreciate . Even if it does appreciate it may not be as pronounced as that of the bond.

Hope this clarifies.

When you buy a convertible bond, you forgive a portion of the yield in exchange for a guarantee: the company stock. Each convertible bond can be exchanged for a fixed amount of stocks. In T0, the risk manager will calculate the best convertible ratio that covers the inherent risk of the operation. How the risk manager would consider credit risk into the valuation? The book states that changes in credit spreads may put the investor in a position that the convertible ratio is more favorable or less favorable than initially expected.

This risk analysis revolves around the embedded guarantee of the convertible bond.

I think you are mistakenly correlating two separate issues. CF is used for short delivery so that the contract is honored and short squeeze do not impact credit default. CR I limited to the same issuer that has its stocks traded in the market.

Upon making the recap, I came across this topic again :slight_smile:
So, the idea is: conversion ratio: bond par divided by share price
Higher bond value (spreads narrow), a more “valuable” bond relative to shares -> better/higher conversion ratio
And the other way around, when spreads widen?
Many thanks!