DEFINITION of Bond Floor
The bond floor is the lowest value that convertible bonds can fall to, given the present value of the remaining future cash flows and principal repayment.
The term ‘bond floor’ also refers to the aspect of constant proportion portfolio insurance that ensures that the value of a given portfolio does not fall below a predefined level.
BREAKING DOWN Bond Floor
Convertible bonds give investors the potential to profit from any appreciation in the price of the issuing company's stock, if converted. This added benefit to investors makes a convertible bond more valuable than a straight bond. In effect, a convertible bond is a straight bond plus an embedded call option. The market price of a convertible bond is made up of the straight bond value and the conversion value, which is the market value of the underlying equity into which a convertible security may be exchanged. When stock prices are high, the price of the convertible is determined by the conversion value. However, when stock prices are low, the convertible bond will trade like a straight bond, given that the straight bond value is the minimum level a convertible bond can trade at and the conversion option is nearly irrelevant when stock prices are low. The straight bond value is, thus, the floor of a convertible bond.
Investors are protected from a downward move in the stock price because the value of the convertible bond will not fall below the value of the traditional or straight bond component. Stating this differently, the bond floor is the value at which the convertible option becomes worthless because the underlying stock price has fallen substantially below the conversion value.
How to Calculate the Floor of a Convertible Bond
For example, assume a convertible bond with a $1,000 par value has a coupon rate of 3.5% to be paid annually. The bond matures in 10 years. A comparable straight bond has the same face value, credit rating, interest payment schedule, and maturity date of the convertible bond, but has a coupon rate of 5%. To find the bond floor, calculate the present value (PV) of the coupon and principal payments discounted at the straight bond interest rate.
where C = coupon rate of convertible bond
P = par value of convertible bond
r = yield on straight bond
n = number of years until maturity
PV factor = 1 – [1 / (1 + r)n]
= 1 – [1/(1.05)10
PVcoupon = [(3.5% x $1,000)/ 0.05] x 0.3861
= 35/0.05 x 0.3861
=$700 x 0.3861
PVpar value = [$1,000 / (1.05)10]
= ($1,000 / 1.6289)
Bond floor = PVcoupon + PVpar value = $613.91 + $270.27
Bond floor = $884.18
Even if the company’s stock price falls, the convertible bond should trade for a minimum of $884.18. Like the value of a regular, non-convertible bond, a convertible bond’s floor value fluctuates with market interest rates and various other factors.
The diﬀerence between the convertible price and its bond ﬂoor is the risk premium, which can be viewed as the value that the market places on the option to convert a bond to the underlying shares.
Constant Proportion Portfolio Insurance
Constant proportion portfolio insurance (CPPI) is a mixed portfolio allocation of risky and non-risky assets, which varies depending on market conditions. An embedded bond feature ensures that the portfolio does not fall below a certain level, thus, acting as a bond floor. The bond floor is the value below which the value of the CPPI portfolio should never fall in order to ensure the payment of all future due interest and principal payments. By carrying insurance on the portfolio by means of this embedded bond feature, the risk of experiencing more than a certain amount of loss at any given time is kept to a minimum. At the same time, the floor does not inhibit the growth potential of the portfolio, effectively providing the investor with a lot to gain and only a little to lose.