The Convertible Debt Market: Are Returns Worth the Risk?

Abstract

Convertible bonds made up about 6 per cent of the almost $700 billion total corporate domestic debt market at the end of 1987. Non-investment-grade (high-yield) convertible debt accounted for 67 per cent of the rated convertible debt issued that year, but only 48 per cent of the market in dollar terms. The high-yield convertibles overall were not as high-yielding as their straight debt counterparts; companies issuing convertibles obviously pay a lower interest rate in exchange for the conversion sweetener. Convertibles provided a fairly good return to investors over the 1983-87 period-slightly above the returns on the S&P 500 and NYSE and slightly below those on high-yield straight debt and long-term governments. The strong correlation between convertible returns and stock returns was reflected in the exceptional performance of convertible bond funds over the 1978-87 period, when they almost doubled the performance of high-yield straight debt and long-term government funds. They did less well, however, over the more recent three and five-year subperiods. In the case of default, convertible bonds, like straight debt, sell at significant discounts from par value. Over the 1980-87 period, total convertibles, including both high and low grades, had an average default rate of 1.24 per cent per year (including Texaco's massive Eurobond default), versus 0.32 per cent for total straight debt. The recovery rate after default was also lower for convertibles than for straight debt (36.4 per cent of par, versus 43.2 per cent). The average annual loss on the total convertible debt market was thus higher than that on the total straight debt market (0.69 per cent, versus 0.16 per cent). The average annual default loss on high-yield convertibles, however, was 1.75 per cent (versus 1.17 per