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Quantitative Research As the growth in the market for convertible bonds continues across the globe, the
Luke Olsen
Convertible Bond Asset Swap has become an increasingly popular mechanism to
+44 (0)20 7773 8310
luke.olsen@barcap.com match the specific risk-reward requirements of investors to the many properties of a
convertible bond.
Convertible Research
Douglas Decker, CFA A Convertible Bond Asset Swap (CBAS) separates the convertible bond into two
+44 (0)20 7773 8302
douglas.decker@barcap.com distinct components, a Convertible Bond Option (CBO) and a Callable Asset Swap
(CAS), with notably different characteristics. The Convertible Bond Option retains the
Haidje Rustau “optionality” of the convertible bond and, as such, is aimed at investors who are
+44 (0)20 7773 8301
haidje.rustau@barcap.com predominantly interested in the embedded equity option of a convertible bond. The
Callable Asset Swap would be of particular interest to investors who wish to invest in
Judy Ho
+44 (0)20 7773 9682
the credit of the convertible bond issuer without the risk associated with the underlying
judy.ho@barcap.com equity.
Convertible Bond Sales This report aims to introduce the reader to the convertible bond asset swap and to
Karam Deol explain both its structure as well as the advantages and risks of entering into such a
+44 (0)20 7773 8320
karam.deol@barcap.com transaction. It is assumed that the reader is familiar with convertible bonds and their
properties, although we recommend the Barclays Capital publication, Convertible
Alan Welch Bonds: A Technical Introduction, for those wishing to review.
+44 (0)20 7773 8320
alan.welch@barcap.com For further information on convertible bond asset swaps and on the services provided
by Barclays Capital, please visit our website at www.barcap.com/cbonds.
Table of Contents
Introduction 3
Key Features of Convertible Bond Asset Swaps 3
Why Do Fixed Income Investors Enter into Callable Asset Swaps? 4
Who is a Typical Callable Asset Swap Investor? 4
Why Do Equity Derivative Investors Purchase Convertible Bond Options? 4
Who is a Typical Convertible Bond Option Holder? 4
Summary 17
Glossary 18
The convertible bond • The convertible bond is split into a fixed income component, the callable asset
asset swap separates swap (CAS), and an option to buy the convertible bond (CBO).
a convertible bond into
• The CAS is created when the fixed income investor buys the convertible bond,
two separate
sells an option to repurchase the bond and enters into an interest rate swap to
components, a fixed
exchange the fixed coupons for floating coupons of LIBOR plus a credit spread.
income component
This transaction results in a structure where cash flows due to the investor are
and an option to
equivalent to a callable floating rate note. The callable nature of the structure
purchase the
removes the sensitivity to the underlying equity of the convertible bond and
convertible bond
enables the investor to receive a higher spread over LIBOR than would be
achieved in a conventional non-callable asset swap on a straight bond.
• The CBO holder is the owner of an option to purchase the convertible bond at a
price equivalent to the value of the fixed income component of a convertible
bond with a specified credit spread. This convertible bond option is not just an
option on the underlying equity but on the convertible bond itself, so its value
depends on the factors that influence the price of the convertible. However, the
option holder is protected against adverse movements in the convertible bond
over and above the option premium.
• The CBAS is structured to mature at either the maturity of the convertible bond
or, if the convertible bond can be “put” back to the issuer for early redemption,
then to the next “put” date.
• Convertible bonds that are suitable for structuring as a CBAS typically have
between six months and five years remaining to the first put date or maturity.
• To ensure the CAS investor receives a minimum return from their investment, a
“make whole” penalty may be included to discourage the CBO holder from
exercising their option before a set date.
• Market convention when quoting the price of a CBAS is to quote the spread
over LIBOR that the CAS investor would receive. This also applies to the
convertible bond option where the spread is used to determine the strike price
at which the convertible bond can be repurchased. The bid is the spread over
LIBOR at which an investor is willing to buy the credit (enter into a CAS). The
offer is the spread at which the CBO holder is willing to offer the credit.
• The CBAS can only be terminated early if the option holder exercises their right
to repurchase the convertible bond. If a CAS investor wishes to flatten the
position before termination, the investor could enter into an opposite CBAS
transaction, effectively netting the two positions.
• CBAS are OTC structures, so while a standard structure is generally followed,
the terms and conditions can be tailored for each convertible issue or investor.
CAS investors are able • Due to supply and demand imbalances, many convertible bond issues trade at
to receive a higher higher implied spreads over LIBOR than equivalent issues within the straight
yield than both corporate bond and / or credit default swap markets. The CAS allows fixed
straight and income investors to profit from this market anomaly.
convertible bonds
• The investor realises a higher yield on a CAS investment versus the convertible
bonds due to the compensation received for the call option that they have sold
to the CBO holder. The yield pick-up depends upon the credit risk and volatility
of the issuer’s credit.
• Convertible bonds generally have a different maturity profile versus straight
bonds of the same issuer, offering a diversification benefit along the yield curve.
• The CAS may offer diversification by sector, country and credit quality not
available via the straight corporate bond market.
• Fixed income investors can benefit from their unique credit insights for an issuer
without taking the equity risk inherent in convertibles.
• Some fixed income funds have mandates that forbid any investment in equity-
related products. By removing the equity risk, a CAS allows investors to isolate
the fixed income component of the convertible bonds.
• Commercial banks;
• Money market funds;
• Insurance companies;
• Fixed income bond funds;
• Pension funds; and
• Investment banks.
CBO investors are able • The credit risk of the issuer is mitigated / hedged.
to limit their exposure
• The convertible bond option buyer may take a view on either the underlying
to the credit risk of the
equity or the volatility of the equity.
convertible bond
issuer • Downside is limited to the option premium paid when purchasing the CBO.
• Buyers of the CBO may have more expertise in equity derivatives than credit
analysis and hence seek to isolate the equity component.
• The CBO investor must only finance the cost of the convertible bond option
rather than the whole convertible bond position. This can allow far greater
leverage for an investor than by owning the convertible bonds outright.
• Hedge funds;
• Mutual funds;
• Equity / warrant funds;
• Investment trusts; and
• Trading desks.
Par (100%)
Callable
Asset Convertible Bond Barclays
Swap Bank PLC
Investor
CB Option
Source: Barclays Capital.
The CAS investor Cash Flows for the Duration of the Trade
swaps the coupons Over its lifetime, the Callable Asset Swap investor will pay / receive the following cash
from the convertible flows (see Figure 2):
bond for payments of
LIBOR plus the agreed • Receive the fixed coupons from the convertible bond.
spread • As part of the interest rate swap, receive floating payments of LIBOR + Spread
and pay the fixed coupons from the convertible bond.
Fixed Coupons
Callable
Asset Barclays
Swap Bank PLC
Investor Floating Leg, LIBOR
+Credit Spread
Fixed
Coupons
Convertible
Bond
Source: Barclays Capital.
Callable
Asset Par (100%)
Convertible
Swap Bond
Investor
If the option is If the CBO holder wishes to repurchase the convertible bonds, or the issuer calls the
exercised then the convertible bonds, the investor (see Figure 4):
option holder
• Returns the convertible bond to Barclays Bank PLC, who will cancel the interest
repurchases the bonds
rate swap.
from the CAS investor
at a defined price • Receives par from Barclays Bank PLC.
• Receives the accrued floating rate payment from the last floating rate payment
date to the settlement date of the option transaction (ie, until the convertible
bonds are in the possession of Barclays Bank PLC).
• Receives or pays the mark-to-market value of the interest rate swap, which is
usually a small amount and is due to movements in the yield curve since the
last floating rate payment date (see below).
To unwind the interest rate swap, an equal and opposite interest rate swap must be
effectively entered into (see Figure 5), thus cancelling all future cash flows. However,
if the settlement date of the option transaction occurs between floating leg payment
dates then there will be a cash flow mismatch at the next payment date. This
mismatch will be comprised of the accrued floating leg due to the client and, if interest
rates have moved, a payment from / to the investor of the mark-to-market value of the
interest rate swap. Because these cash flows are due at the next floating leg payment
date, they are discounted from the payment date to the option settlement date.
Original
Interest
Rate Sw ap
Interest Rate
Sw ap to cancel
the original
Interest Rate
Sw ap L+Spread
Example
Example of a CAS The Olivetti 1.5% 2004 convertible bond was issued at a price of 100% but redeems at
structure for the 105.078%. The bond pays a coupon of 1.5% annually on 1 January each year until
Olivetti 1.5% 2004 maturity on 1 January 2004. The following describes the mechanics of a callable asset
convertible bond swap entered into at a spread of 180 basis points.
Par (100%)
Callable
Asset Barclays
Swap Bank PLC
Investor
Olivetti 1.5% 2004
Source: Barclays Capital.
• The investor enters into an interest rate swap with Barclays Bank PLC, whereby
they receive LIBOR + 1.80% quarterly and pay the fixed coupons (see Figure
7). The back-end redemption amount of 5.078% is included in the interest rate
swap.
Convertible
Bond
Source: Barclays Capital.
• The result for the CAS investor is a callable floating rate note with a face value
of 100% that pays a floating coupon of three-month LIBOR + 1.80%, quarterly
in arrears.
• If the convertible bond matures then the issuer will redeem the convertible bond
at a price of 105.078%. However, the fixed back-end payment of 5.078%
payable by the investor results in the net redemption for the callable asset swap
investor of 100% (see Figure 8).
105.078%
Convertible
Bond
Source: Barclays Capital.
The CBO is structured At the beginning of the transaction, the CBO buyer sells convertible bonds and
so that the investor receives an option to repurchase the convertibles at a strike price dependent upon the
effectively purchases negotiated spread. The option holder receives a cash amount equal to the “investment
an option to buy back value” for the convertible bonds, which is effectively the value of the fixed income
the convertible bonds component.
This investment value is calculated by considering the CBO holder’s position as being
equal and opposite to that of the callable asset swap investor. Hence, the investor
receives par and enters into a swap receiving the fixed coupons from the convertible
bond and paying the floating leg of LIBOR + Spread until maturity. In practice, an
interest rate swap is not entered into, and instead, the net present value of the swap is
calculated and deducted from par to give the “investment value” (see Figure 10).
Investment
Value
Barclays
Convertible
Capital
Bond Option
Securities
Holder
Ltd. Convertible
Bond
Source: Barclays Capital.
If the option is When the option holder exercises the option, the transaction is reversed and the
exercised, the investor investor pays the investment value of the convertible bond to repurchase the
pays the “investment convertible bonds. The investment value is determined using the agreed spread at the
value” to repurchase inception of the trade and the settlement date of the option exercise transaction. Thus,
the convertible bonds the “investment value” is effectively the strike price of the convertible bond option. The
Example
Example calculation of In Figure 11, we provide an example of the investment value calculations for a simple
the investment value convertible bond asset swap, using the Olivetti 1.5% 2004 convertible bond to
for the Olivetti 1.5% illustrate. Each floating leg is calculated using EURIBOR and the negotiated credit
2004 convertible bond spread of 180 bp. All payments are then discounted back to the settlement date of the
transaction. (NB. We quote the clean investment value below)
On entering into the transaction, the investor sells the convertible bond to Barclays
Capital Securities for the investment value of 98.657% of par, and acquires the
convertible bond option. If the investor exercises the option, they will pay the
investment value to repurchase the convertible bonds. An investor who owned the
convertible bond option and wished to exercise their option on the above date would
have to pay 98.657% of par to repurchase the bonds.
A callable asset swap investor could buy the credit for the “investment value” given
above rather than enter into an interest rate swap and pay par, if they wished to
receive fixed rather than floating cash flows.
Protection for the CAS Investor From Immediate Exercise of the CBO
To protect the CAS Since the CBO can be exercised from the trade date, the option holder could exercise
investor from early immediately if market conditions move swiftly in their favour. For the CAS owner, this
exercise a number of exercise would curtail any cash flows. Therefore, certain penalties are typically
penalties are used to established to protect the credit buyer from early exercise of the CBO. The two most
discourage the CBO common features are the “make whole” and “bullet” penalties.
holder
“Make Whole” Penalty
The “make whole” penalty that would be payable by the CBO holder typically exists for
three to six months after inception of the CBAS and guarantees that the credit buyer
receives a cash flow of the accrued spread up to the “make whole” date, regardless of
whether the option is exercised before this date.
Hence the “make whole” penalty formula is:
Settlement Date
100% of the Option
Transaction
Make Whole
date
“Bullet” Penalty
Similar to the “make whole” penalty, the “bullet” penalty requires the option holder to
pay an additional penalty (typically 0.5-1.0% of par) if the option is exercised within a
set period. Most CBAS structures have either a “make whole” or “bullet” penalty, but
rarely both.
“Recall” Spread
Lastly, the “recall spread” also discourages early exercise of the option. In this case,
the CBO holder must repurchase the bonds at a tighter spread (typically 5-10 bps)
than the initially negotiated spread. This increases the investment value and hence the
repurchase cost of the convertible bonds. In absolute cash terms, this penalty
diminishes to zero as the time to maturity decreases (see Figure 13).
Figure 13: Recall Spread Increases the Investment Value and Hence the
Repurchase Price
Investment
Value
Maturity Settlement
100% Date of the
Option
Recall Credit Transaction
Spread
Original Credit
Spread
The mark-to-market For the CAS investor, the value of their position must be:
value of the CAS can
Callable Asset Swap = Convertible Bond Price + NPV of Interest Rate Swap – CBO
be determined by
considering each This reflects the CAS investor’s position of holding the convertible bond, being short
component of the CAS an option to repurchase this convertible bond and having entered into an interest rate
seperately swap paying fixed coupons and receiving LIBOR plus the agreed spread. The value of
the position will be 100% of par if the CBO has an intrinsic value greater than zero
(see below). However, if the credit spread of the issuer widens and the CBO has an
intrinsic value of zero then the value of the CAS investor’s position will be less than
100% of par. This reflects the investor’s position of being exposed to the default risk of
the issuer yet benefiting from the premium they have received for selling the option.
Intrinsic value of the Whilst calculation of the CBO’s theoretical value (including its “time value”) requires a
CBO is the greater of more quantitative approach, it is straightforward to calculate its intrinsic value.
CB price less the
Convertible Bond Option = Max (Convertible Bond Price – Investment value, 0)
Investment Value and
zero This equation represents the profit that would be made from immediately exercising
the option, purchasing the convertible bond for its investment value, and selling it
immediately for its market price. Thus, if the market price of the convertible bond falls
below the strike price, it would not be beneficial for the option holder to exercise (the
intrinsic value of the option is zero). However, although the intrinsic value is zero,
there may be time value associated with the probability of the convertible bond price
rising above the investment value before maturity.
CBO The CBO is sensitive to the underlying value of the equity in the same way as a
convertible bond. An increase in the equity price will increase the value of the
convertible bond and hence the convertible bond option (see Figure 14). The option
should have similar theoretical values of delta and gamma as the convertible bond,
provided there has been no change in the credit quality of the issuer.
CAS If the option is “in the money”, then the callable asset swap investor will be insensitive
to equity price changes. The position is effectively capped at par, since investors
receive par if the option is exercised. If the option moves “out of the money” due to an
adverse change in credit quality, there can be some dependence on the underlying
equity. However, in this scenario the sensitivity to the underlying equity will be minimal
in comparison to the sensitivity to the default risk of the issuer.
Figure 14: Sensitivity of the Convertible Bond Option to the Underlying Stock
Price.
Convertible
Bond Price
Value of Convertible
Bond Option
Investment
Value of the
CB Option
Investment value of
the Convertible
Bond
Equity Price
CBO An increase in the volatility of the underlying equity will increase the value of the
convertible bond and, consequently, the value of the convertible bond option.
CAS The callable asset swap has no sensitivity to equity volatility if the option is “in the
money”. If the option is out of the money then the sensitivity to volatility will be minimal
and lower than even the sensitivity to the underlying equity.
CBO For a convertible bond option holder, an improvement in the issuer’s credit quality
increases the value of the convertible bond and the convertible bond option.
Conversely, if the credit deteriorates sufficiently, the option’s value will approach zero
(see Figure 15), but whereas the CBO investor’s downside is limited to the option
premium a CB investor’s downside is the whole value of the CB.
CAS The callable asset swap investor has the opposite position. An improvement in credit
quality of the issuer would not benefit the investor if the option is “in the money”, as
the value of the position is capped at par. However, for an “out of the money” option,
the investor is sensitive to credit quality. An increase in the default risk of the issuer
will be detrimental to the CAS investor’s position. Note that the option premium
effectively gives the callable asset swap investor a cushion against adverse credit
spread movements of the issuer.
Figure 15: Profit and Loss for both Convertible Bond and CBO Investors from
Changes in the Default Risk of the Issuer
P&L
CBO
CB
Credit Credit
Deteriorates Improves
CBO For the convertible bond option holder an increase in credit spread volatility is positive
because the CBO is effectively an option on the credit quality of the issuer. An
improvement in the credit quality of the issuer increases the value of the convertible
bond but any deterioration is capped because the convertible bond option can never
be worth less than zero. The value of this credit spread option is significantly higher for
a convertible bond with a low parity.
CAS For the CAS investor, credit spread volatility is negative because the investor is
effectively short a credit spread option to the CBO holder. The investor’s position is
CBO The interest rate sensitivity of a convertible bond option depends on the difference in
interest rate sensitivity of the convertible bond and of its investment value. Generally,
the interest rate sensitivity of a convertible bond is less than that of the equivalent
straight bond. Therefore, an increase in interest rates reduces the investment value
more than the convertible bond value. As a result, an increase in interest rates will
increase the intrinsic value of the convertible bond option and vice versa. However,
since the value of the option cannot be less than zero, the investor effectively has an
option on interest rates.
CAS Like a callable floating rate note, the callable asset swap has little sensitivity to interest
rate movements.
Acknowledgements:
The authors would like to thank the Barclays Capital Convertible Bond and CBAS
traders for their valuable contributions to this document. For further market and / or
technical enquiries please contact the CBAS traders through your nominated sales
representative.
Quantitative Research
Luke Olsen
+44 (0)20 7773 8310
luke.olsen@barcap.com
Convertible Bond Sales
Karam Deol Alan Welch
+44 (0)20 7773 8320 +44 (0)20 7773 8320
karam.deol@barcap.com alan.welch@barcap.com
Credit Strategy
Gary Jenkins Jim Reid
Global Head of Credit Research +44 (0)20 7773 9533
+44 (0)20 7773 9691 jim.reid@barcap.com
gary.jenkins@barcap.com
Corporates
Juan Carrion Suzanne Cassidy Janice Davidson
(Autos / Media / Leisure) (Industrials – Chemicals / Pharma) (Retail / Consumer)
+44 (0)20 7773 8476 +44 (0)20 7773 8482 +44 (0)20 7773 9692
juan.carrion@barcap.com suzanne.cassidy@barcap.com janice.davidson@barcap.com
James Ravine Jon Scoffin Michelle Boath
(Industrials – Basic Industries) (Industrials – Engineering / Property) (Junior Analyst)
+44 (0)20 7773 8533 +44 (0)20 7773 9139 +44 (0)20 7773 8256
james.ravine@barcap.com jon.scoffin@barcap.com michelle.boath@barcap.com
Telecommunication / OEMs
Stephan Michel Laura Winchester Milena Ianeva (Junior Analyst)
+44 (0)20 7773 8392 +44 (0)20 7773 9688 +44 (0)20 7773 8536
stephan.michel@barcap.com laura.winchester@barcap.com milena.ianeva@barcap.com
Financial Institutions
Roberto Bella Larissa Knepper Guido Versondert
+44 (0)20 7773 8418 +44 (0)20 7773 9138 +44 (0)20 7773 9799
roberto.bella@barcap.com larissa.knepper@barcap.com guido.versondert@barcap.com
Public Sector
George Johnston
+44 (0)20 7773 9690
george.johnston@barcap.com
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