Barclays Capital

An Introduction to Convertible Bond

Asset Swaps
Convertible Bond Research 8 August 2002

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
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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

The Mechanics of a Convertible Bond Asset Swap 5

Callable Asset Swap 5
Convertible Bond Option 9

Why Would the Option Holder Exercise Their Option? 11

Protection for the CAS Investor From Immediate Exercise of the CBO 11

Intrinsic Value of the Convertible Bond Asset Swap 13

Callable Asset Swap 13
Convertible Bond Option 13

Market Sensitivities of the Convertible Bond Asset Swap 14

Equity Price Sensitivity 14
Equity Volatility 15
Default Risk of the Issuer – Credit Spread 15
Credit Spread Volatility 15
Interest Rates (Risk Free) 16

Summary 17

Glossary 18

2 Convertible Bond Research Barclays Capital

 Introduction
Key Features of Convertible Bond Asset Swaps

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.

Barclays Capital Convertible Bond Research 3

 Why Do Fixed Income Investors Enter into Callable Asset Swaps?

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.

Who is a Typical Callable Asset Swap Investor?

• Commercial banks;
• Money market funds;
• Insurance companies;
• Fixed income bond funds;
• Pension funds; and
• Investment banks.

Why Do Equity Derivative Investors Purchase Convertible Bond Options?

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.

Who is a Typical Convertible Bond Option Holder?

• Hedge funds;
• Mutual funds;
• Equity / warrant funds;
• Investment trusts; and
• Trading desks.

4 Convertible Bond Research Barclays Capital

 The Mechanics of a Convertible
Bond Asset Swap
Callable Asset Swap

The CAS is structured Initialisation of the Trade

to represent a callable In a Callable Asset Swap, the CAS investor enters into the following transaction (see
floating rate note Figure 1):
paying LIBOR plus a
spread • Pay par and receive the convertible bond.
• Enter into an interest rate swap whereby they receive LIBOR + the agreed
spread on par (the floating leg) and pay the fixed coupon from the convertible
bond. The value of LIBOR used for the floating leg is typically set at the
beginning of a three-month period, for payment at the end of the period.
• Write to the counterparty an option to repurchase the convertible bonds at par,
adjusted for the accrued floating leg and the mark-to-market value of the
interest rate swap (see later).

Figure 1: Initial Transaction in a Callable Asset Swap

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.

Figure 2: Cash Flows Throughout the Duration of a Callable Asset Swap.

Fixed Coupons
Callable
Asset Barclays
Swap Bank PLC
Investor Floating Leg, LIBOR
+Credit Spread

Fixed
Coupons

Convertible
Bond
Source: Barclays Capital.

Barclays Capital Convertible Bond Research 5

 The overall cash flows resemble a floating rate note paying
LIBOR + Spread

Termination of the Trade

If the CAS matures The trade will be terminated in one of two ways: either the callable asset swap will
without the option mature or the option to repurchase the convertible bonds will be exercised.
having been exercised
If the CBAS transaction matures (either at maturity or put date of the convertible bond)
then the issuer
with the CBO unexercised, the issuer will redeem the bonds (see Figure 3).
redeems the
convertible bonds Figure 3: Redemption of the Convertible Bond at Maturity of the Callable Asset
Swap

Callable
Asset Par (100%)
Convertible
Swap Bond
Investor

Source: Barclays Capital.

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).

Figure 4: Cash Flows if the Convertible Bond Option is Exercised

Par (100%) + Accrued

Floating Leg ± Unwind
MTM Value of the Swap
Callable
Barclays
Asset
Bank
Swap
PLC
Investor
Convertible
Bond
Source: Barclays Capital.

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.

6 Convertible Bond Research Barclays Capital

 Figure 5: Cancellation of Interest Rate Swap Using an Equal and Opposite Swap
Floating Leg Coupons
F+Spread

Original
Interest
Rate Sw ap

Fixed Leg Coupons

α β

Fixed Leg Coupons

Interest Rate
Sw ap to cancel
the original
Interest Rate
Sw ap L+Spread

Floating Leg Coupons

Settlement Date of the
Option Exercise
Transaction

Where, F = Floating Rate for the current Calculation Period.

L= Floating Rate for the Calculation Period from the Settlement Date of
the Option Transaction to the next applicable Floating Rate Payment
Date.
Spread = the negotiated Credit Spread at the inception of the CBAS.
α = the actual number of days in the Calculation Period from the last
applicable Floating Rate Payment Date to the Settlement Date of the
Option Transaction.
β = the actual number of days in the Calculation Period from the
Settlement Date of the Option Transaction to the next applicable
Floating Rate Payment Date.
D= Days in a year according to day basis used.

The exact cash payments are:

Accrued floating rate payment is PVF × (100% × (F + Spread ) × α D )

Mark-to-market value of the interest rate swap is PVF × (100% × (F − L ) × β D )

1
Where PVF = , the discount factor from the next floating rate payment
1 + (L × β D )
date to the settlement date of the option transaction.
Special features of the As noted earlier, the structure can be easily tailored to meet the requirements of the
convertible bond and / client and the features of the underlying convertible bond. For example, many
or client requirements convertible bonds redeem at a price above par. In this case, the interest rate swap is
can be accommodated structured to include a back-end payment that is paid by the callable asset swap
within the CBAS investor to Barclays Bank PLC. This ensures that, at maturity, the net cash flow to the
structure callable asset swap investor is par. If the convertible bond option is exercised, this
back-end payment is cancelled.

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.

Barclays Capital Convertible Bond Research 7

 • The investor initially pays par and receives the convertible bond from Barclays
Bank PLC (see Figure 6).

Figure 6: Initial Transaction for the Callable Asset Swap

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.

Figure 7: Ongoing Cash Flows for the Callable Asset Swap

1.5% Payable annually

Callable
Asset Barclays
Swap Bank PLC
Investor 3 Month LIBOR +
1.80% payable
quarterly in arrears
1.5%
Payable
annually

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).

Figure 8: Cash Flow if the Convertible Bond Matures

Callable 5.078% Barclays

Asset
Bank
Swap
PLC
Investor

105.078%

Convertible
Bond
Source: Barclays Capital.

8 Convertible Bond Research Barclays Capital

 If the convertible bond option is exercised, the callable asset swap investor returns the
convertible bond in exchange for par plus accrued interest and the unwind cost of the
interest rate swap, as noted earlier (see Figure 9).

Figure 9: Cash Flows if the CBO is Exercised

Par (100%) + Accrued

Floating Leg ± Unwind
MTM Value of the Swap
Callable
Barclays
Asset
Bank
Swap
PLC
Investor Olivetti
1.5% 2004
Source: Barclays Capital.

Convertible Bond Option

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).

Figure 10: Initial Transaction for a Convertible Bond Option Holder

Investment
Value
Barclays
Convertible
Capital
Bond Option
Securities
Holder
Ltd. Convertible
Bond
Source: Barclays Capital.

The “investment value” received by the option buyer is:

100% +å PV (Fixed Coupons)-å PV (LIBOR + Spread)
(Note: this is the “dirty” price for the investment value as it includes the accrued fixed
coupon since the last coupon payment date. To quote a “clean” investment value, we
subtract the accrued fixed coupon. In practice, the investment value is quoted with the
same convention as the underlying bond.)
Hence the net cost of the convertible bond option is:

Convertible Bond Option = Convertible Bond – Investment Value

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

Barclays Capital Convertible Bond Research 9

 greater the negotiated credit spread, the lower the investment value and the higher the
option value. As time to maturity decreases, the investment value approaches par,
although it will fluctuate with interest rates.

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)

Figure 11: Calculation of Investment Value for Olivetti 1.5% 2004

Olivetti 1.5% 2004
Par Amount 100 Investment Value 98.657
Nominal 1000
Coupon 1.50% Accrued Coupon 0.785
Redemption Price 105.078 Net Present Value 99.442
Spread (bp) 180
Today 08 Jul 02
Settlement Date 11 Jul 02
Maturity 01 Jan 04
FLOATING LEG FIXED LEG
Date Fl. Rate Spread Amount PV Amount PV
01-Oct-02 3.43% 1.80% 1.191 1.182
01-Jan-03 3.56% 1.80% 1.370 1.347 1.500 1.475
01-Apr-03 3.79% 1.80% 1.397 1.361
01-Jul-03 3.97% 1.80% 1.459 1.407
01-Oct-03 4.18% 1.80% 1.529 1.459
01-Jan-04 4.35% 1.80% 1.572 1.484 6.578 6.207
Source: Barclays Capital.

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.

10 Convertible Bond Research Barclays Capital

 Why Would the Option Holder
Exercise Their Option?
The option holder will At maturity of the CBAS, the option holder would exercise the right to repurchase the
exercise at maturity of convertible bonds if the option is “in the money”. If the CBAS is structured to mature
the CBAS if the on a put date of the convertible, the option will be in the money if the convertible is
convertible bond value trading above the put price. The value of the option can be realised by exercising the
is greater than the option and repurchasing the convertible bond, then immediately selling the
redemption price convertible. If the CBAS is structured to mature when the convertible bond matures,
then the option holder will exercise if parity of the convertible bond is greater than the
redemption amount. The value of the option is realised by repurchasing the
convertible bonds and converting into the underlying equity.
Under certain Exercise prior to maturity of the CBO can occur for a number of reasons:
circumstances it
• If the convertible bond issuer calls the bonds for early redemption then the
would be beneficial for
option is automatically exercised.
the option holder to
exercise prior to • If the option holder no longer wants exposure to the convertible bond then the
maturity of the CBAS holder can exercise the option and sell the repurchased convertible bonds, thus
realising the option’s value.
• If the credit quality of the issuer improves significantly then the option holder
can exercise the option and enter into another asset swap at a tighter spread.
This crystallises the profit from credit quality improvement and reduces the
maximum loss that can occur if the convertible bond price subsequently
declines.
• A lack of liquidity in the convertible bond may result in an artificially high price.
An option holder can exercise their option to repurchase the bonds and sell
them to capture this pricing anomaly.

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:

“Make Whole” Penalty = Spread × PVF × ω D

Where, ω = Number of days between the settlement date of the option
exercise and the end of the “make whole” period
PVF = Discount factor from the “make whole” date to the settlement
date of the option exercise (see above).
D = Days in a year according to day basis used
If the option is exercised, the cash price received by the callable asset swap investor
is as follows (see Figure 12).

Barclays Capital Convertible Bond Research 11

 Figure 12: Cash Value of the Credit Spread to be Received by the Investor if the
Option is Exercised
Net cash value of the credit spread
payments

Settlement Date
100% of the Option
Transaction
Make Whole
date

Source: Barclays Capital.

“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

Source: Barclays Capital.

12 Convertible Bond Research Barclays Capital

 Intrinsic Value of the Convertible
Bond Asset Swap
Callable Asset Swap

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.

Convertible Bond 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.

Barclays Capital Convertible Bond Research 13

 Market Sensitivities of the
Convertible Bond Asset Swap
A qualitative We present here a simplified description of how each risk factor will affect the value of
description of the both the Callable Asset Swap and the Convertible Bond Option, when all other
various risk factors variables are kept constant. For brevity, we use the terminology “in the money” to
that will affect the describe an option that has a positive intrinsic value, while “out of the money” is used
mark-to-market value for an option of zero intrinsic value.
of the CBO and CAS
investor’s position Equity Price Sensitivity

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

Out of the money In the money

Convertible Bond Convertible Bond
Option Option
Source: Barclays Capital.

14 Convertible Bond Research Barclays Capital

 Equity Volatility

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.

Default Risk of the Issuer – Credit Spread

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

Source: Barclays Capital.

Credit Spread Volatility

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

Barclays Capital Convertible Bond Research 15

 capped at par if credit quality improves whilst an increase in the default risk of the
issuer is detrimental to the investor’s position.

Interest Rates (Risk Free)

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.

16 Convertible Bond Research Barclays Capital

 Summary
The Convertible Bond Asset Swap repackages a convertible bond into a fixed income
component and an option to repurchase the convertible bond. This structure allows
investors with differing risk / reward requirements to isolate the different components
of a convertible bond. The chief advantage of the convertible bond asset swap is that
it allows a variety of investors to unlock value that is embedded within the convertible
bond. Without taking equity risk, the fixed income investor buys exposure to the credit
of a convertible bond, which typically trades wider than comparable straight corporate
bonds. The convertible bond option holder is able to gain equity exposure without
credit risk.
The fixed income investor enters into the Callable Asset Swap, a position equivalent to
a callable floating rate note, by paying par and receiving the convertible bond. Then,
the investor enters into an interest rate swap, swapping the fixed coupons of the bond
for a floating leg of LIBOR plus the agreed spread. Finally, the investor has also sold a
call option on the CB allowing the counterparty to repurchase the bonds for a price of
par plus accrued. For this, they receive a further yield pick-up over the convertible
bond, depending on the properties of the bond.
The CBO investor purchases an American-style option to repurchase the convertible
bond at a price equal to the corresponding investment value of a callable asset swap
struck at the agreed credit spread. This structure allows the investor to limit exposure
to adverse credit movements of the issuer, while still participating in the equity
component of the convertible bond. The convertible bond option also implicitly
incorporates an option on the credit quality of the issuer.
To discourage the convertible bond option holder from exercising their option shortly
after entering into the transaction and reducing returns for the fixed income investor, a
number of penalties may be included. A “make whole” penalty guarantees a minimum
return to the callable asset swap investor. A “recall” penalty requires the option holder
to exercise the option at a higher strike price than that originally struck. It is analogous
to paying the bid / offer spread in a conventional bond position.
The theoretical valuation of a convertible bond option requires a quantitative
approach. However, it is straightforward to calculate the intrinsic value of the option
(and hence the callable asset swap). The details are found within the preceding text.
In conclusion, we have shown that the Convertible Bond Asset Swap is a relatively
simple structure with very interesting properties for many investors. As this market
continues to grow, both fixed income and equity investors will be able enter into
attractive investments that are tailored to their investment criteria.

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.

Barclays Capital Convertible Bond Research 17

 Glossary
CBAS Convertible Bond Asset Swap.
CBO Convertible Bond Option is an American-style call option to repurchase the convertible
bonds at the “investment value”.
CAS Callable Asset Swap is the fixed income component of a convertible bond.
Constructed by swapping the fixed coupons of the convertible for a floating coupon
and selling a call option on the convertible bonds.
Investment Value The strike price of the CBO, calculated by considering the net present value of a
transaction that receives par, receives fixed coupons from the convertible bond and
pays floating coupons of LIBOR plus the agreed Spread. Values the fixed income
component of the Convertible Bond.
Make Whole A penalty introduced to ensure that the CAS investor receives cash value of the credit
spread up to a negotiated date, the “make whole” date.
Recall Spread A penalty to discourage rapid turnover of a CBAS position by the CBO holder. The
recall spread is the credit spread used to calculate the investment value, and hence
strike price, at which the CBO holder can repurchase the convertible bonds when they
exercise their option.

18 Convertible Bond Research Barclays Capital

Barclays Capital Convertible Bond Research 19
Barclays Capital
European Credit Research
Barclays Capital
5 The North Colonnade Phone: +44 (0)20 7773 9022
London E14 4BB Fax: +44 (0)20 7773 7389

Convertible Bond Research

Douglas Decker Haidje Rustau Judy Ho
+44 (0)20 7773 8302 +44 (0)20 7773 8301 +44 (0)20 7773 8303
douglas.decker@barcap.com haidje.rustau@barcap.com judy.ho@barcap.com

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

Utilities, Oil & Gas

Neil Beddall Andrew Moulder Paula Dahlen (Junior Analyst)
+44 (0)20 7773 9879 +44 (0)20 7773 8558 +44 (0)20 7773 8589
neil.beddall@barcap.com andrew.moulder@barcap.com paula.dahlen@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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