Synthetic Convertible Bonds

What are Synthetic Convertible Bonds?

Synthetic convertible bonds are financial instruments that blend elements of both debt and equity securities. However, unlike traditional convertible bonds where the issuer is typically responsible for both the debt and equity components, synthetic convertibles separate these responsibilities. These bonds grant investors the option to convert them into shares of a company other than the bond issuer. The issuer remains accountable solely for the debt portion of the security, while another entity, often an investment bank, assumes responsibility for the equity component. This unique structure allows for flexibility and risk diversification within a single instrument.

How Do Synthetic Convertible Bonds Work?

Synthetic convertible bonds function as hybrid securities that combine features of traditional bonds and convertible securities. The conversion feature typically allows investors to exchange their bonds for a predetermined number of shares at a specified price, offering potential upside if the underlying stock price appreciates. This particular instrument type offers investors an opportunity to convert their bonds into shares of a company other than the bond issuer.

Structured with parameters resembling conventional convertible securities, such as conversion ratio and premium, synthetic convertibles offer several distinct advantages. They typically exhibit higher credit quality due to risk spreading across different entities. Moreover, they remove the debt burden from the share issuer, contributing to a more balanced capital structure.

Advantages

1. Higher Credit Quality. Synthetic convertible bonds often exhibit higher credit quality compared to traditional convertible bonds. This is due to the separation of responsibilities between the issuer, who is typically responsible for the debt portion only, and a third party managing the equity component. As a result, investors benefit from reduced credit risk.

2. Diversification within One Instrument. Synthetic convertibles provide investors with exposure to both debt and equity markets and to different entities within a single security. By blending fixed-income and equity features, investors can diversify their portfolios efficiently, spreading risk across different asset classes and potentially enhancing overall portfolio stability.

3. No Additional Debt Burden on Share Issuer. Unlike traditional convertible bonds, where the issuer assumes both debt and equity responsibilities, synthetic convertible bonds remove the debt burden from the share issuer. This contributes to a more balanced capital structure for the issuing company, potentially enhancing its financial health and creditworthiness.

4. Participation in Potential Equity Upside. Synthetic convertible bonds offer investors the opportunity to participate in the potential upside of the underlying stock price appreciation. Through the conversion feature, bondholders can exchange their bonds for shares at a predetermined price, allowing them to benefit from any increase in the stock price beyond the conversion price.

5. Flexibility in Investment Strategy. Due to their unique structure and customizable features, synthetic convertible bonds provide flexibility in investment strategy. Investors can use these instruments to achieve specific investment objectives, whether seeking income from fixed-income assets, potential capital appreciation from equity exposure, or a combination of both.

Examples of Synthetic Convertible Bonds

1. GS Finance Corp, 0% 5jun2023, USD. This synthetic convertible bond is issued by GS Finance Corp and provides investors with an option to convert the bond into the cash value of the shares of Fidelity National Information Services. With a zero percent coupon rate, and a maturity date of June 5, 2023, this bond offers investors exposure to both fixed-income and equity markets within a single instrument.

2. Barclays Bank PLC, 0% 4feb2025, USD. Another example of a synthetic convertible bond is issued by Barclays Bank PLC. Similar to the first example, this bond features a zero percent coupon rate and matures on February 4, 2025. Investors holding this bond have to convert it into the cash value of the shares issued by Microsoft Corporation at some point before or on the maturity date.

Understanding Synthetic Convertibles

Bank-issued structured notes represent a significant component of the synthetic convertible bond market. They retain attributes of convertible securities, including conversion ratios and premiums, but with a critical difference: the credit risk is not borne by the company whose stock underlies the convertible but by a third party. However, during times of financial stress, such as the 2008 financial crisis, these notes may carry significant counterparty risk. Investors should carefully evaluate the creditworthiness of the third-party entity when considering bank-issued structured notes as part of their investment strategy.