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Credit in Convertible Bonds: A Critical View1

By Zouheir Ben Tamarout, Dexia Asset Management

Convertible Bonds (CBs) are corporate debt securities that confer on the holder the right to exchange them for a pre-specified number of ordinary shares of the issuer. In theory, a CB may be viewed and valued as a package of a straight bond and a call on the underlying equity. In practice, the different terms describing a realistic Cb (callability by the issuer, putability by the holder) make it impossible to decouple the bond from the equity option. Convertible bonds, as hybrid products mixing interest rate, equity, volatility and credit factors, are the best representatives of the intrinsic interrelationship between market and credit risk. Although this lack of separability is widely recognized, there had been very few published models including (rigorously) default risk in the pricing of CBs2. To our knowledge, very few articles have discussed the impact of parameters calibration on the Cb value and sensitivities and on the underlying credit spread curve. Existing approaches to modeling credit risk may be classified into three groups: structural, reduced-form and hybrid. The structural approach directly relates default and the firms assets. The firm defaults when its assets fall below its debt (or an exogenously given level). A major advantage of this approach is that it explicitly links the credit event to firm-specific variables. It has proven very useful in understanding many empirically observed results that show that the number of business failure is influenced by macro-economic variables, or that returns on high yield bonds, compared to investment-grade bonds, are more correlated to equity index returns. Unfortunately, implementing this approach faces practical problems due to the complexity of the firms capital structure, to its evolution across time (we believe that the capital structure evolves in order to keep a constant equity-debt ratio) and to the non-respect of priority rules. In the reduced-form approach (intensity models), default is treated as an unpredictable event governed by a hazard-rate process. Default events can never be expected (technically speaking, the time of default is an inaccessible stopping time). The modeled hazard-rate represents the likelihood of the firm defaulting over the next period. Loss on default is captured by an exogenous (possibly stochastic) recovery rate. The parameters of these models may be fitted to market spread curves. An attractive feature of this approach is its ability to imply realistic short credit spreads3 Spread curves are not constrained to start at zero and slope upward as with structural diffusion models. Hybrid models combine attractive features from both approaches. They aim to provide a structural interpretation to the parameters of intensity models, and to meet empirical observations. Although the hazard rate process (on which they are based) is not formally linked to the firms assets, it is allowed to depend on macroeconomic and firm-specific variables. Here, we explore the use of a simple hybrid model in convertible bond pricing. Through this paper we seek to demonstrate the important impact of credit risk integration on the value and sensitivities of CBs. We also show the practical issues raised by model calibration and parameter interpretation. The used model is a simplified adaptation of the model introduced by Madan and Unal in their article (March 2000) A Two-Factor Hazard Rate Model for Pricing Risky Debt and the Term Structure of Credit.

The model: We adopt the mathematical framework of Duffie and Singleton (1994/1999). We take as given an equivalent risk-neutral measure Q, under which the price process of any contingent claim, discounted with the money market account (the numeraire), is a martingale. Specifying all the technical assumptions is out of the scope of this paper. The basic ingredients of our model (like many others) are a stopping time for default and a random bounded recovery at default. The interpretation of this recovery will be discussed below. Following Madan and Unal, we suppose that the firm faces multiple random losses at random time. These losses (adverse movement in financial markets, international crisis, default of a creditor or a customer) are not necessarily fatal. The firm goes bankrupt only when the loss is serious enough to absorb the equity value. We assume that a Poisson process (with an intensity ) governs the loss event. Our formulation allows for the

intensity to be a stochastic process, as far as some non-arbitrage constraints are met. This is referred to as a Cox Process. The hazard rate of default is given by:

ht dt = Q[( [t , t + dt[ ) (L S )]
where denotes the event random time, S the stock price and L the loss amount (by share) experienced at . This is the instantaneous risk-neutral probability of default at time t, given survival to t. Assuming that the loss event intensity is independent of the loss magnitude, the hazard rate of default can be simplified:

ht = Q[ L S ]
The hazard rate equals the arrival intensity times the probability that the loss is large enough to destroy the equity value. One more assumption is needed on the loss distribution in order to calculate this probability. Many loss distributions commonly used in the literature can be viewed as a mixture of exponential distributions. The famous Pareto distribution is an example where the gamma function is used as a mixing distribution. In our simplified approach, a single exponential distribution is used:

S Q[ L S ] = exp m
where m is the (risk-neutral) expected loss. The probability of exceeding the mean loss decreases exponentially with the loss magnitude. The survival probability of the firm until a given maturity T, given survival to t, is related to the hazard rate by:

T S S (t , T ) = EtQ exp ht dt where ht = exp t m t

The expectation is taken under the risk-neutral probability and takes into account all the information available at time t. Upon default, bondholders receive a fraction of their investment. This is the recovery rate. Jarrow and Turnbull (1995) define this recovery in terms of an equivalent risk-free bond with an identical cash flow structure. Duffie and Singleton (1999) define it in terms of the risky bond immediately before the default event occurs. Unfortunately, these (mathematically convenient) academic definitions are inconsistent with market practice. The legal documentation specifies recovery in terms of outstanding principal amount plus current accrued interest. This is the approach we choose here. For illustrations sake, we assume that the recovery rate and the risk-free interest rate curve are given constants. The assumption of a constant recovery is obviously at odds with reality. There is strong evidence that the recovery rate depends on the seniority of the issue and exhibits a pronounced state-dependency (business cycle). Although our model can handle stochastic recovery, we elect to keep it constant for two reasons. In order to simplify calculations, we actually suppose that recovery is independent (under Q) of interest rates and default time. This assumption allows us to replace the stochastic recovery by a its expected value (under Q). We also show that estimating the recovery alone is very touchy because of lack of relevant data. Randomness will rather be introduced through the loss intensity. In most practical cases, optionality due to stochastic interest rates can be neglected (at a first approximation) when valuing a CB. This explains the market practice of managing CBs with a single-factor (equity only) model. According to our interpretation of available literature on the subject, we also suppose that interaction between interest rates and credit risk can be ignored at this stage. However, extension of this approach to two factors is straightforward. This issue will be explored in future work.

Pricing corporate bonds: Based on previously available results in a more general framework (Jarrow and Turnbull, 2000), the market value at time t (given survival to t) of a corporate bond with promised coupon payments {Ci} at time {Ti} (i =1,,n) and redemption value F at T=Tn, is:

n Ti Ti V (t , T ) = 1 >t EtQ C i exp (rt + ht )dt + F exp (rt + ht )dt i = m (t ) +1 t t Ti n s + 1 >t EtQ W (F + C i ( s Ti 1 ) )hs exp (rt + ht )dt ds 1,t ) i = m (t )+1 Max (Ti t
where is the stopping time for default, r the (stochastic) spot rate, and W the constant recovery rate. m(t) is the last coupon index. T0 stands for the issue date. In this formula, we represent the value of the risky bond as the value contingent on survival through maturity (first term) plus the sum of cash flows generated on default in each of the coupon periods (second term). Note that this formula is based on the legal recovery approach. Contrary to the risk-free claim and risky claim cases mentioned above, the risky bond is not strippable under legal recovery approach (par claim). The bond can not be represented by a sum of discounted risky cash flows with the same behavior at default. Standard stripping procedures do not apply in our case. In order to determine the underlying zero-coupon curve, other stripping methods are used. It is worth noting that recovery introduces a kind of continuous (possibly random) coupon payment given by:

ct = htW (F + C i (t Tm (t ) ) )
Preliminary tests: We test our exponential assumption on a real corporate issue: the Adelphia Communication 9.875% 1/3/2007. This is a senior straight bond noted B+ by S&P and B2 by Moodys. We use historical spreads (versus Libor Swaps) from Bloomberg, between 1/10/98 and 10/9/2000. The bonds (continuous) credit spread can be approximated by:

y (t , T ) =

T 1 Ln EtQ exp ht (1 W )dt T t t

where W denotes the constant recovery rate. This approximation can be justified under the risky claim recovery approach (Duffie and Singleton), for a zero-coupon, when interest rates are independent from the hazard rate and the recovery rate. Note that, for bonds trading around par, par claim and risky claim approaches are close. Using our calibrated parameters (the calibration procedure is exposed below), we calculate the bonds yield for each stock level reached on the historical path. Theoretical and historical yields are plotted (versus the stock price) in Exhibit 1.
6.50 6.00 5.50 5.00 4.50 4.00 3.50 3.00 2.50 2.00 1.50 20.00

0.15 0.1 0.05 0 -0.15 -0.1 -0.05 -0.05 -0.1

30.00 40.00 50.00 60.00 70.00 Market 80.00

0Exhibit 2a 0.05

0.1

0.15

-0.15 Exhibit 2a Market Model

Exhibit 1a

Model

The exponential shape looks reasonable, but does not capture the variability of the real world. Its failure can be accentuated through the Exhibit 2a of changes in credit spreads versus changes in stock price. Contrary to the perfect anti-correlation assumed by our model, changes in spread and stock price are roughly non-correlated. By introducing a stochastic arrival intensity (as a lognormal process governed by an independent Brownian motion), we get obviously closer to reality (see Exhibit 2b). Here, we suppose that the arrival intensity has no drift, a volatility of 35% and a correlation of 0.2 with stock price.

0.15 0.1 0.05 0 -0.15 -0.1 -0.05 -0.05 -0.1 -0.15 Exhibit 2b Market Model 0Exhibit 2a 0.05 0.1 0.15

Pricing convertible bonds: As an equity contingent claim subject to default risk, the CB solves a modified Black-Sholes partial differential equation (PDE) with specified boundary conditions. This PDE captures the hazard-rate and the recovery.

P 1 2 2 2 P P + S + (r d ) S + f ( P, t , S ) + c t = ( r + h) P 2 t 2 S S
where S is the stock price, its volatility and d its dividend rate. F(P,t,S) represents predetermined flows (coupons) paid to the holder. In solving this PDE, we follow the finite difference approach with a Crank-Nicolson scheme. We dont describe this method here since it is covered extensively elsewhere. It is important to understand that, through the PDE mentioned above, we are actually solving a free boundary problem. In other words, our numerical method has to be accurate enough to deal correctly with the early termination events. Here, we prefer to focus on the available data and the impact of our calibration choices on the final results. To demonstrate our approach, we consider a real example: Versatel 4% 30/03/2005 convertible bond. This CB has been issued in March 2000, is convertible since May 9th to 16.4582 shares and callable from 30/03/2002 to maturity. The underlying issuers calls are soft, i.e., they are exercisable when the equity price exceeds some given triggers. The CB is a non-subordinated issue, rated B- by S&P and B3 by Moodys. Versatel is a telecommunication company of the Netherlands. It offers basic and business telephone, fast Internet access and data access services. All the simulations are performed on September 1st. Versatel stock has a price of 32 EUR. It has no projected dividends, exhibits a volatility of 90% and a repo rate of 1.5% (treated as a continuous dividend).

Calibrating the model: In our PDE, three parameters should be chosen in order to reflect the available data. These are the intensity, the mean loss and the recovery rate. Note that the mean loss appears necessarily through its ratio to the share price. Likewise, the recovery rate appears always through the product W . The lack of default history precludes statistical inference of the hazard rate. Estimating the model parameters should take advantage of the data at hand: the issuers credit spread curve, recovery historical estimations, and the historical relationship linking spreads to the stock price. Spreads are relative to Euro swaps, rather than treasuries. The spreads that we retain correspond to a B graded issuer (rather than a B-). Spreads and swap rates are graphed in Exhibit 3.

8 7.5 7 6.5 6 5.5 5 4.5 4 Sep-00 Exhibit 3 Jun-03 Mar-06 Sw ap Rates Nov-08 Credit Spreads Aug-11

Data compiled by Moodys for the period 1974-1997 show that, for senior unsecured bonds for example, recovery rates range approximately between 30 (25th percentile) and 75 (75th percentile). The median is around 50. Moodys measures the recovery rate as the value of a defaulted bond as a fraction of face value. Given our definition (including accrued interest) and our perception of the Telecom industry in general and Versatel accounting information in particular, we believe that 30% is a realistic (and perhaps optimistic) expected recovery rate for our CB. This is our historical (actual) estimation of the recovery rate. It would differ from the risk-neutral recovery effectively used in the model. For this exogenously given recovery rate, we attempt to calibrate the model to the initial credit spread term structure. These spreads are understood to be active for similar non-convertible bonds of the same issuer, i.e., straight bonds with a comparable coupon (4%) and redemption value. We put maximal weights on the two points we believe the most important for the problem at hand: the CB maturity and the very short term. The former is fixed at 7.15 and the latter at 6.0. It is easy to see that the very short-term (continuous) spread is given by:

S s = (1 W ) exp m
Relating the long-term spread to the model parameters is more complicated. The calibration on the CBs maturity is performed numerically. Once the intensity and the mean loss are chosen, the other points of the spread curve are implied for the same coupon rate (4%). For each maturity, a straight bond (coupon of 4%) is priced with the model. The retained implied spread is the parallel shift to apply to the risk-free curve in order to get the same price (traditional approach). The theoretical curve (T30) is compared to the market curve in Exhibit 4. Calibration succeeds to fit the target spreads but at the cost of an unacceptable shape for the spread curve. We repeat the same operation for different recovery rates. A better fit to the term structure is obtained for a lower recovery of 10%. The theoretical curves (T10 and T20) are also in Exhibit 4.
7.6 7.4 7.2 7 6.8 6.6 6.4 6.2 6 Sep-00 Exhibit 4

Jun-03

Mar-06 Market T30

Nov-08 T10 T20

Aug-11

In our approach, fitting any spread curve seems to necessitate a global calibration of the intensity, the mean loss and the recovery rate. In the risky claim approach, recovery and intensity are completely linked through the expected loss rate (1 W ) . Other things being equal, any couple ( , W ) keeping the expected loss constant will provide the same curve structure. This structure is of course attainable in our model with W null. It is worthwhile pointing out that the low-coupon bonds used above, trade far below their face value (under par). With our legal interpretation of the recovery rate, the quoted credit spread depends on the coupon rate. A higher coupon bond should trade on a higher spread than a bond with a lower coupon. In fact, at default, both bonds generate approximately the same recovery (relatively little differences are due to the accrued interest). It is, thus, preferable to invest in lower-coupon bonds. In order to quantify this par claim effect, we plot the model implied spread curve for bonds (with a coupon of 12.8%) trading around par (see Exhibit 5). As expected, the par claim effect is significant for higher recovery rates. This result would suggest calibrating the model to bonds trading at par.
8.5 8 7.5 7 6.5 6 Sep-00 Exhibit 5

Jan-02

Jun-03 T30

Oct-04 T10

Mar-06

Jul-07

Nov-08

Apr-10

Aug-11

T30_AtPar

T10_AtPar

The stocks volatility enters the default risk at two levels. First, it increases the hazard rate drift, implies a lower survival probability and then a higher credit spread. On the other hand it increases the hazard rate volatility, causes a higher survival probability and thus narrower spreads. The latter effect is due to the fact that the riskneutral survival probability S(t,T) is an expectation of a convex function (we use Jensen s inequality). For a given recovery rate (here 20%), we repeat the calibration for different volatility levels. We attain comparable term structures on the 0-5Y range. For longer maturities, a higher volatility seems to extend the positive trend in the spread curve slope (see Exhibit 6). The effect of volatility is more obvious when the other parameters are kept constant (intensity=13.8%, mean loss=50, recovery=20%). The credit curve is steeper (and becomes positive) for higher volatilities. This effect is shown in Exhibit 7.
7.6 7.4 7.2 7 6.8 6.6 6.4
5.5 6 7 6.5 7.5

6.2 6 Sep-00 Exhibit 6 Jun-03 Market Mar-06 Vol=40 Nov-08 Vol=60 Aug-11 Vol=90
5 Sep-00 Exhibit 7

Jun-03 Vol=30

Mar-06 Vol=60

Nov-08 Vol=90

Aug-11

In order to demonstrate the effect of the models parameters, we plot in Exhibit 8 the curve evolution for different quads (stocks volatility, mean loss, intensity, recovery). Thus, we cover a large spectrum of levels and shapes.
18 16 14 12 10 8 6 4 2 0 Sep-00 Exhibit 8 Jun-03 Mar-06 Nov-08 Aug-11

Credit risk in CBs: In the traditional approach, CBs are valued and hedged with a deterministic credit spread (possibly a term structure). Practitioners usually use spreads implied by similar non-convertible issues. They dont take into account the coupon differential, and unnecessarily penalize the equity upside by discounting it at higher interest rates. Many alternatives have been used in order to adjust the spread (empirically, or as a function of the delta and / or the conversion probability) when the Cb gets into the money. These are partial solutions that dont correctly account for all the cash flows due to coupon payments, and embedded calls and puts. More importantly, they dont handle credit as a risk factor in its own right. In our approach, credit spread is linked to the stock price through the mean loss. When the stock falls, the credit spread deteriorates. The CB doubly suffers. Its conversion value shrinks and its bond floor decreases. We calibrate the model to the initial spread term structure, for a given volatility of 90%. Although making the arrival intensity depend (deterministically) on time should guarantee a perfect fit to the initial curve, keeping it constant will not invalid our results. Our theoretical prices are compared to the traditional approach in Exhibit 9a. Deltas are plotted in Exhibit 10a and expressed as a percentage of the CB ratio (16.4582). Note that, in these graphs, all the parameters, except the stock price, are invariable: = 90, = 11.4, m = 52.0, W = 10.
1650.0 1550.0 1450.0 1350.0 1250.0 1150.0 1050.0 950.0 850.0 750.0 1.00 Exhibit 9a 21.00 41.00 Flat Spread 61.00 Model 81.00
100.0% 90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% 1.00 Exhibit 10a 21.00 41.00 Flat Spread 61.00 Model 81.00

The evolution of the hedge ratio may look reasonable at first glance. Due to credit risk, the models hedge ratio exceeds the traditional approach recommendation. In order to demonstrate the importance of parameters choice, we calibrate the model to the markets spread curve for a lower stock volatility: = 42, = 23.0, m = 22.6, W = 0. Results are represented in Exhibit 9b (CB price versus stock price) and Exhibit 10b (hedge ratio versus stock price).
1600.0 1400.0 1200.0 1000.0 800.0 600.0 400.0 1.00 Exhibit 9b

120.0% 100.0% 80.0% 60.0% 40.0% 20.0% 0.0% 1.00 Exhibit 10b

21.00

41.00 Flat Spread

61.00 Model

81.00

21.00

41.00 Flat Spread

61.00 Model

81.00

As the stock price decreases, the CBs delta decreases first (conversion effect) before going up (credit effect). The attained levels, however, seem too high. Two plausible reasons for this: - The model compensates for other missing factors (interest rates, arrival intensity). - Keeping the models parameters constant when the stock falls is a hazardous assumption. In such a scenario, the firm could be downgraded. Its spread curve and mean loss parameter should be reviewed in order to reflect its new situation. Our approach raises another debatable point. Given the deterministic dependence of the hazard rate on the stock price, the model infers a spread curve scenario for each possible future value of the state variable (stock price). Some practitioners build their own scenarios of credit spread relative to stock price. This is comparable, in spirit, to pricing an option on volatility by guessing its future evolution (as a function of the stock price). But does this approach imply a realistic dynamics for the volatility?

Conclusion: The key ingredient to the model we are seeking is its ability to capture the spreads dynamics, and to correctly price and hedge CBs, as well as corporate debt. This is a very ambitious target. We believe that measuring the hedging power of this model would be the unique way to judge its ability to capture the relevant risks. The purposes of this paper, however, are modest. They can be summarized as follow: - To critically introduce the models behavior and recommendations when used to trade CBs. - To demystify credit risk by integrating it with market risk, following Jarrow and Turnbull. Our model suggests five determinants for credit spread. These are the stocks price and volatility, the mean loss, the arrival intensity and the recovery rate. - To warn against black boxes for credit risk pricing. Different interpretations of available data could generate important bias. The same data can be used differently (calibration process) and lead to unexpected effects. - To show that choosing / including a credit risk model is a critical task. Its impact is important enough to be handled with a great caution. The present model should be viewed as an illustrative example, nothing more. During the last years, we saw a proliferation of credit risk models. Pragmatic ideas are forcing their way. Ben Jonson said: True happiness consists not in the multitude of friends, but in the worth and choice.

Selected References: D. Duffie, D. Lando, June 1997, Term Structures of Credit Spreads with Incomplete Accounting Information D Duffie, K. Singleton, 1999, Modeling Term Structures of Defaultable Bonds Review of Financial Studies 12

R.A. Jarrow, S.M. Turnbull, 1995, Pricing Options on Financial Securities Subject to Credit Risk, Journal of Finance 50 (1) R.A. Jarrow, S.M. Turnbull, 2000, The Intersection of Market and Credit Risk, Journal of Banking & Finance 24 (2000) C.L. Keatinge, Working paper, Modeling Losses with the Mixed Exponential Distribution D. Lando, Working paper, 1994/1997, On Cox Process and Credit Risky Securities Moodys Investors Services, January 1996, Corporate Bond Defaults and Default rates 1938-1995) C. Zhou, March 1997, A Jump-Diffusion Approach to Modeling Credit Risk and Valuing Defaultable Securities
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Implementation has been achieved by Olivier Clapt (Financial Programmer) We wish to acknowledge the comments and suggestions of all our Alternative Investment teams, particularly Convertible Bonds and High Yield managers.

K. Tsiveriotis and C. Fernandes proposed (see Valuaing Convertible Bonds with Credit Risk) a rigorous framework with two coupled Black-Scholes PDEs in order to correctly introduce the credit spread. Zhu introduced a jump-diffusion process (in a structural approach) in order to capture the basic features of credit spread structures. Duffie and Lando studied the implication of imperfect accounting information and showed that imperfect observation of firms assets is consistent with a hazard-rate approach.