Convertible Bond for a Family Office
A family office is considering a $5 million allocation to a 5-year convertible bond issued by a mid-cap technology company. The bond pays a 3.25% coupon, is convertible at a 32% premium to the current $40 share price, and is callable after year three at par. The issuer's straight 5-year debt yields 6.1%, the stock's dividend yield is 1.0%, and 3-year implied volatility is 38%. The family office targets 5% annual income and can tolerate no more than a 10% drawdown over any 12-month period. Its investment policy permits convertible bonds but prohibits unlisted securities and requires at least $2 million in daily liquidity for any position. The issuer's shares trade $18 million per day. A broker describes the bond as 'equity upside with bond protection' and notes the conversion option is 'free' because the coupon is above the dividend.
1. Decompose the convertible into its components and assess whether the 'free option' claim is accurate.
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A convertible is a straight bond plus a call option on the issuer's stock; the investor pays for the option through a lower coupon and the conversion premium. Here the straight 5-year yield is 6.1%, but the convertible coupon is 3.25%, so the annual coupon give-up is 2.85% of par-about $142,500 on $5 million. The 32% conversion premium means the stock must rise above $52.80 before conversion has intrinsic value. The 'option is free' claim is wrong: the option is paid for with foregone income and upside sharing. The call feature after year three also caps upside if the issuer redeems. The correct comparison is the convertible's bond floor plus option value versus a straight bond plus separately purchased calls.
2. Assess the convertible against the income target, drawdown limit, liquidity policy, and policy constraints.
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Income: 3.25% of $5 million is $162,500, below the $250,000 needed for a 5% target. Drawdown: the straight-debt yield of 6.1% implies a bond floor around 88% of par-roughly 12% below par-so credit spread widening alone can breach the 10% limit; equity weakness would add to the loss. Liquidity: the underlying shares trade $18 million per day, but the convertible itself may trade over the counter and the policy requires $2 million daily liquidity-verify dealer depth and issue size. Policy permits convertibles, but the position fails the income target, has a plausible drawdown above 10%, and may fail liquidity. It is not suitable at $5 million as described.
3. How could the family office structure a suitable alternative using the same issuer?
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Use the same issuer but separate the exposures. Buy a straight bond sized to meet income and liquidity: $4.5 million at 6.1% yields about $274,500, above the $250,000 target, and keep $500,000 for listed call options or a smaller convertible. Listed calls are permitted if listed; they cap loss at the premium and preserve upside. Alternatively, reduce the convertible to $1.5-2 million, pair it with a Treasury ladder for liquidity, and set a written drawdown trigger. A charitable remainder trust is not appropriate because it is irrevocable and not needed for the stated goal. The key is to avoid paying for an embedded option that the client cannot hold through a drawdown.