What Is a Premium Put Convertible?

A premium put convertible is a type of bond that combines the features of put bonds with the attributes of convertible bonds. Like a put bond, a premium put convertible can be redeemed for cash at the discretion of the bondholder. Like a convertible bond, a premium put convertible can be converted into shares of the company's stock at a preset rate.

Key Takeaways

  • A premium put convertible is a type of bond that combines the features of put bonds with the attributes of convertible bonds.
  • Premium put convertibles seem to offer investors an ideal combination of limited losses and unlimited gains.
  • However, premium put convertibles make investors pay for their benefits in the form of lower interest rates, and their puts can be problematic.
  • The interesting features of premium put convertibles can be duplicated using exchange-traded funds (ETFs) and options while reducing risks.

Understanding Premium Put Convertibles

Figuring out how the put feature works is the first step to understanding premium put convertibles. A put option gives the owner the right, not the obligation, to sell a security at a specified price within a defined timeframe. Like a put option on a stock, this feature includes a strike price. The strike price is a value at which a specific derivative contract can be exercised.

The strike price for an ordinary put bond will typically be below the issue price of the bond. However, a premium put convertible allows for an alternate arrangement where the strike price is higher with restrictions on when the embedded put can be exercised. For example, the market price of the bond or the company's shares might have to rise above a certain level. In cases where stock and bond prices rise, the company should find it easier to pay off bondholders.

The other half of understanding premium put convertible bonds is learning how the convertibility trait works. Convertibility allows the bondholder to convert the bond into an agreed-upon number of shares of the underlying stock. The ratio at which the bond exchanges for shares is the conversion ratio. The conversion ratio is determined at the time of issue and impacts the relative price of the security. The conversion involves no exchange of cash or funds, only shares of the underlying asset.

Premium put convertibles can only be converted on a single day. However, rolling put convertibles are able to be converted on multiple dates.

Advantages of Premium Put Convertibles

Premium put convertibles seem to offer investors an ideal combination of limited losses and unlimited gains. Theoretically, the put feature can protect investors if the issuing company does poorly. If the issuer does well, the convertible feature allows premium put convertible bonds to be exchanged for the company's stock.

Disadvantages of Premium Put Convertibles

The first disadvantage of premium put convertibles is their low-interest rates. Obviously, having protection in the form of a put and potential for higher returns due to stock convertibility are desirable features. These features come at a cost, and that cost usually comes in the form of lower interest rates.

The second issue is the construction of the put feature. A typical put bond has the strike price set below the bond's issue price, and it can be exercised to limit any losses that might occur. The story is different for a premium put convertible with restrictions requiring the bond's market price to reach a higher strike price before it can be exercised. If the company does poorly, the bond price might never rise to the strike price. In that case, the put provides no protection because it cannot be exercised.

Finally, the interesting features of premium put convertibles can be duplicated using exchange-traded funds (ETFs) and options while reducing risks. For example, an investor might buy a bond ETF, buy a put on it to limit downside potential, and buy a call option on a stock ETF. Like premium put convertibles, such an arrangement reduces maximum losses and allows for more gains, but it also benefits from more diversification.

Buying call and put options directly gives investors much more control over their risks and rewards than the embedded options in premium put convertible bonds.

Example of a Premium Put Convertible Bond

Consider an investor who owns a premium put convertible bond with a face value of $1,000, a coupon rate of 4%, and a put feature at a strike price of $1,200. Suppose that the put feature also has a restriction requiring the market price to reach the strike price before it can be exercised. Finally, each bond can be converted to 10 shares of the underlying stock of XYZ company.

With one year left before maturity, the bond reaches its strike price of $1,200. The investor may then exercise the put option and sell the bond back to the issuer at $1,200. Alternately, the bondholder may convert the bond to 100 shares of XYZ stock. If the XYZ share price goes above $120 per share, this would be an attractive option.