Convertible Bonds and Hybrid Securities: Equity Upside with a Bond Floor

Introduction to Hybrid Securities

The boundary between debt and equity is not as sharp as it might appear. Between the senior secured bond (which has strong contractual payment obligations and high priority in insolvency) and ordinary shares (which have no contractual claim on earnings and the lowest priority in a wind-up) lies a spectrum of hybrid securities that blend characteristics of both.

Understanding hybrid securities matters because they appear widely in diversified portfolios — sometimes deliberately purchased for their asymmetric return profiles, sometimes held unknowingly within bond funds. The key is to understand what you own: hybrids are not simply safer versions of equities, nor are they simply higher-yielding versions of bonds. They carry specific, often complex risks that differ meaningfully from both.

Convertible Bonds: The Basics

A convertible bond is a corporate bond that can be converted into the issuing company's shares at a predetermined price — the conversion price — at the option of the bondholder (or sometimes the issuer), during a specific period. Until conversion, it pays interest like a regular bond. At or after maturity, the investor can either take repayment of the principal in cash or convert into shares.

The conversion premium is the amount by which the conversion price exceeds the current share price at issuance. A company with shares trading at £10 might issue a convertible with a conversion price of £12.50 — a 25% conversion premium. For conversion to be attractive, the share price must rise to at least £12.50 before the maturity date.

Why companies issue convertibles: A company can issue a convertible bond at a lower interest rate than a conventional bond of the same maturity, because the equity option has value that investors are effectively paying for through accepting lower coupon payments. Convertibles are therefore a cheaper source of financing for growth companies where investors believe the equity story.

Why investors buy convertibles: The convertible offers an asymmetric payoff profile. If the company's shares rise substantially above the conversion price, the convertible appreciates with the shares — the investor has effectively owned equity but with a fixed-income floor underneath. If the company's shares fall or go nowhere, the investor collects the bond coupons and receives principal repayment — a pure fixed-income return.

The Delta and the Bond Floor

Two technical concepts determine how a convertible behaves at any given moment:

The bond floor is the theoretical minimum value of the convertible treated purely as a bond — ignoring the conversion option. It is calculated by discounting the remaining coupon payments and principal repayment at the appropriate discount rate for a comparable straight bond from the same issuer. The convertible should trade at or above this floor.

When the underlying share price is well below the conversion price — when the conversion option is "deeply out of the money" — the convertible behaves very like a straight bond. Its price is near the bond floor; interest rate and credit spread movements are the primary drivers.

The delta is the sensitivity of the convertible's price to movements in the underlying share price. A convertible that behaves like a bond has a very low delta (close to zero). A convertible that behaves like equity has a high delta (approaching 1.0 — moving one-for-one with the share price). A convertible in the middle — where the share is near the conversion price — behaves like a mixture.

At-the-money convertibles — where the share price is close to the conversion price — are in the zone where the asymmetric return profile is most pronounced. In a rising market, the delta rises and the convertible participates in equity gains. In a falling market, the delta falls and the bond floor increasingly dominates, limiting losses.

The Asymmetric Return Profile: Theory and Reality

The standard pitch for convertibles is the "asymmetric return profile": upside participation in equity gains, downside protection from the bond floor. This is a genuine structural feature, but the protection is partial and depends critically on credit quality.

The bond floor offers meaningful protection only if the company remains solvent enough to repay the bond. If a company's share price falls 60% because it is approaching financial distress, the bond floor also falls — the credit spread widens dramatically, the discounted value of future cash flows deteriorates, and the floor falls faster than might be expected. In genuine distress, convertibles can lose most of their value.

The asymmetry works best for convertibles issued by fundamentally sound, creditworthy companies where the share price decline reflects a market correction or sector rotation rather than company-specific stress. For high-yield convertibles — those issued by companies with weak balance sheets — the protection is much weaker.

Convertible Bond Funds vs Direct Investment

For most individual investors, the appropriate way to access convertibles is through a dedicated convertible bond fund rather than individual securities. Reasons include:

• Complexity of analysis: Valuing a convertible requires simultaneously modelling the credit risk (bond component) and the equity optionality (equity component). This requires specialist skills.
• Diversification: A single convertible exposes you to a specific company's credit and equity risk. A convertible fund provides diversification across dozens of issuers.
• Liquidity: The convertible bond market is less liquid than mainstream equity or government bond markets. Direct investors may face wide bid/ask spreads; funds can achieve better execution.

Major convertible bond fund managers include Calamos, Lazard, and several UCITS products from European asset managers. Global convertible indices (the FTSE Qualified Global Convertible Index, formerly the Thomson Reuters/Refinitiv Qualified Global Convertibles) provide benchmark options.

AT1 and CoCo Bonds: High Yield, High Risk

Additional Tier 1 (AT1) bonds — also called Contingent Convertible bonds (CoCos) — are a different and considerably more dangerous type of hybrid. They were created after the 2008 financial crisis specifically for banks, to provide capital that can absorb losses without a taxpayer bailout.

The mechanics: AT1 bonds are perpetual bonds (no fixed maturity — they can be called by the issuer at specific dates but need not be). They pay a fixed or floating coupon. Crucially, they contain a loss-absorption mechanism: if the issuing bank's capital ratio falls below a pre-specified trigger level (typically 5.125% or 7% Common Equity Tier 1 ratio), the AT1 is either converted into equity (at a value potentially far below face value) or written down to zero.

The Credit Suisse shock: In March 2023, the Swiss regulator FINMA, in orchestrating the forced merger of Credit Suisse with UBS, ordered that approximately $17 billion of Credit Suisse AT1 bonds be written down to zero. Ordinary shareholders — who rank below bondholders in the standard creditor hierarchy — received at least some consideration (a small amount of UBS shares). This reversal of the normal priority of claims shocked the AT1 market globally, causing significant spread widening across all European bank AT1s. It remains a vivid illustration that AT1 bonds can deliver total loss with very limited warning.

AT1 yields and the risk premium: AT1 bonds trade at substantially higher yields than senior bank bonds — often 200–400 basis points or more. This yield premium is compensation for the loss-absorption risk. However, because the trigger mechanism can be activated suddenly by regulatory decisions, not purely by market prices, the risk is highly non-linear. Normal expected value calculations may not adequately capture the possibility of sudden total loss.

AT1 bonds are classified as professional investor instruments in many jurisdictions and are not appropriate for retail investors who do not fully understand the risk structure. They should not be held in isolation as if they were simply high-yield corporate bonds.

Preferred Shares

Preferred shares (called preference shares in the UK) sit at the intersection of equity and fixed income. They typically pay a fixed dividend — expressed as a percentage of nominal value — rather than a variable equity dividend. In the event of insolvency, preferred shareholders rank below all creditors (including bondholders and AT1 holders) but above ordinary shareholders.

Characteristics of preferred shares:

• Fixed or floating dividend, paid with priority over ordinary dividends
• No voting rights in most cases
• In a liquidation, preferred shareholders receive their nominal value (if assets remain after all creditors are paid) before ordinary shareholders receive anything
• They do not participate in earnings growth or capital appreciation beyond their nominal value
• Many are redeemable by the issuer at a predetermined price after a certain date

Where preferred shares appear: Banks and insurance companies issue preferred shares as a form of quasi-capital. US bank preferred shares are common; the UK market is smaller. Utility companies have historically issued preference shares.

The risk profile: Preferred shares behave like perpetual bonds — they are highly sensitive to interest rate movements (if rates rise, the fixed dividend is worth less and the price falls) and to the credit risk of the issuer. Unlike ordinary shares, they have no growth potential. Unlike bonds, they have lower priority in insolvency. They represent a fairly unattractive combination of risks for many investors, which is why they trade at yields above senior bonds.

Where Hybrid Securities Fit in a Portfolio

For sophisticated investors, a modest allocation to convertible bonds can enhance the risk-adjusted return of a bond portfolio by providing equity participation without the full downside of equities. A dedicated convertible bond allocation of 5–10% within the fixed income portion of a portfolio can be sensible.

AT1 bonds, given their complex risks, should be limited to investors who understand bank regulatory capital structures and are comfortable with the possibility of sudden total loss. Even sophisticated investors should hold them in diversified form through funds rather than in individual securities.

Preferred shares are appropriate only when the investor understands the specific terms, has high conviction in the issuer's creditworthiness, and needs a specific yield profile that ordinary bonds of the same issuer do not provide.

Risks

Hybrid securities carry multiple layers of risk simultaneously. Credit risk (the issuer may default), interest rate risk (fixed payments become less valuable as rates rise), equity risk (convertibles participate in equity market movements), and structural risk (AT1 write-down triggers, preferred share subordination) all apply.

Capital can fall to zero — as demonstrated by Credit Suisse AT1 holders. Tax treatment of coupon payments and potential conversion gains varies by jurisdiction and can be complex for internationally mobile investors. Rules and regulations governing hybrid instruments may change. Seek specialist professional advice before investing in any hybrid security.

How Global Investments Can Help

Our advisers can help you assess whether convertible bond funds or other hybrid instruments are appropriate for your portfolio, explain the specific risks of any product under consideration, and ensure that your fixed-income allocation is structured in a way that matches your risk tolerance and objectives. Contact us to discuss your fixed income and hybrid allocation.