Analyzing the Historical Mispricing of Convertible Bonds

Abstract

The pricing of convertible bonds can be difficult due to their complex payoff structures and the wide range of inputs that need to be considered. Studies have shown that they are historically underpriced in the market, meaning that trade prices consistently fall below their theoretical prices. This study uses the Longstaff-Schwartz Least Squares model to price U.S. convertible bonds issued between September 2015 and August 2020 and confirms their apparent underpricing by approximately 11%. Furthermore, this study finds that the liquidity of convertible bonds is still an important factor in demand, despite a shrinking proportion of hedge funds in the investor base. In addition, there is greater demand for convertible bonds with lower credit risk, underlying stock volatility, and time until maturity. Finally, when investigating the pricing of convertible bonds during the COVID-19 pandemic, a period in which convertible bond issuance skyrocketed, underpricing was exacerbated due to the greater volatility and general risk in the market.