Pricing and Hedging Mandatory Convertible Bonds

Both investors and corporations find some features of equities attractive and others less desirable. The same can be said for bonds, so it is no surprise that a broad range of hybrid derivatives, partly equity-like and partly bond-like, have been created that offer different blends of the preferred aspects of the two. This article looks at mandatory convertibles, about the most equity-like of these instruments. A mandatory convertible pays regular coupon interest for the first part of its life, and then it converts into shares of the firm's stock. The conversion ratio is a function of the terminal stock price, such that there is equity participation on both the upside and the downside, but a bond-like fixed dollar payoff in the middle range. The payoff can be replicated with a long position in plain vanilla bonds and an option spread on the equity. In empirical tests, the valuation model fits well, better than is typical in studies of ordinary convertibles. High coupons and high dividends are favored by the market, i.e., they are associated with overpricing, while longer maturities, high stock price relative to the option strikes and wider credit spreads are associated with underpricing in the market.