Convertible Bonds: Characteristics of an Asset Class

Abstract

This paper provides an empirical analysis of the risk-return performance of international convertible bond markets. The research has three main objectives. First, it highlights the specific features of convertible bonds such as a greater downside risk protection relative to equities. Second, it analyzes how to price convertible bonds by means of different asset pricing models. Three main pricing models are considered, namely the Capital Asset Pricing Model (CAPM), a Factor Model specification, and an extended version of the CAPM that takes into account higher moments. In particular, the higher-moment CAPM model allows getting over the mean-variance criterion and relaxes the return normality and quadratic utility functions hypotheses. Indeed, higher-moment pricing models may be interpreted in the same line of reasoning of the prospect theory. In this perspective, the utility function is better represented by a concave (convex) pattern in the domain of gains (losses), and the curvature in the utility function is such that losses are heavier than gains. Third, this research examines the efficient allocation of convertible bonds in a portfolio context. We analyze how a global portfolio based on global bonds and equities can efficiently accommodate convertible bonds in diverse market conditions. Our empirical findings show that, in some circumstances, the CAPM model fails to capture the specific characteristics of convertible bonds. In contrast, the higher-moment CAPM specification or the factor modeling often estimate more accurately the required rate of return on convertible bonds. Finally, we conclude that convertible bonds should have a non-negligible weight in an optimal portfolio.

Keywords: convertible bonds, downside risk, CAPM, higher-moment CAPM, Factor Analysis, coskewness, efficient portfolio with convertible bonds

JEL Classification: G11, G12, G15