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The market risk determines the parameters for the financial risk of a company; hence the analysis of the market risk highlights main factors, which can have an effect on the credit quality of a company. A sensitivity analysis should make assumptions about the following factors, affecting the earnings situation of every company:

• Business plan/strategy
• Cost structure of the industry (operating efficiencies, R&D costs, labor costs)
• Marketing and distribution network
• Competition (domestic and global, position, product, price)
• Cyclicality of an industry
• Vulnerability to economic cycles (industry maturity, capacity utilization rates, supply and demand for major products and its production inputs–commodity prices)
• Business environment
• Growth potential
• Market share (customer relationship, competitive pricing)
• Industry structure/ industry trends/ life cycle of the industry (risk, financing need and profitability tend to decline over the life cycle of the industry)
• Own position in life cycle/ product mix/ product quality in relation to peer group
• Diversification of business units (revenue streams)
• Geographic diversification
• Political and regulatory environment (deregulation, liberalization, privatization, taxes, political stability, government guarantees and support etc.)
• Exposure to litigation
• Demographics
• Technology transfer
• Barriers of entry.

will have the same meaning in the following paragraphs. Market risk is the uncertainty regarding future earnings of a company and is determined by the industry to a large extent. The quality of earnings is impacted by the variability of sales. The operating leverage, which is a measure of the amount of fixed costs in the operating cost structure of a company, can be another source of the earnings variability.

The higher the relative amount of fixed cost, the higher the operating leverage and hence the operating risk. The operating leverage can be expressed in an equation as the percentage change in operating earnings relative to the percentage change in sales.

Using the very common Markowitz framework for a further analysis of convertibles in fixed income portfolios, we can provide further evidence of the benefits of such positions between 1998 and the beginning of 2004. One weakness in using the Markowitz-type analysis for convertible bonds is that the mean–variance framework assumes the normal distribution of returns. This assumption is not true for convertible bonds, as their return distribution depends on their equity sensitivity. Especially the return distribution for high gamma convertibles has a fat tail on the right side but a relative small tail on the left side. This is a further argument for buying convertibles in the 10–50 percent delta range in fixed income portfolios.

Under the consideration of a nonnormal distribution, the actual efficient weighting for convertibles in mixed fixed income portfolios should be even higher than it is expected.

Investors using convertibles with a delta ranging from 10 to 50 percent in order to enhance volatility adjusted performance should however have a longer term view. In the short term, a severe decline of equity markets could negatively impact the position, but exactly in this delta range the gamma effect of the convertible could be quite significant.

The gamma is the nonlinear factor in the movement of the convertible price caused by the change of the share price. The gamma shows the change in the delta of an option for a given small change in the equity price. Choosing convertibles with a high gamma could protect investors on the downside (but not eliminate it!) as the delta will decline with an increasing speed if the equity falls and vice versa.

Fixed income alternative instruments could change into a balanced issue if the share price recovers sharply. Many bond floor convertibles experienced a kick-in in their deltas when equity markets recovered in 2003. Fixed income investors could select issuers with a stable credit trend and with bond floor convertible characteristics and underweight the straight bonds: this strategy is a convex one: investors earn an excess return in case of a positive equity-market sentiment and have almost nothing to lose (only if the basis widens) when equities do not perform. Besides the bond floor names, convertibles with a delta of no more than 50 percent offer a reasonable return enhancement and more importantly they can lower the volatility of the fixed income/credit portfolio through very low or even negative correlation to other fixed income products. Convertible bonds had a slightly negative correlation to plain fixed income products during the very volatile 7-year period since 1997. The correlation with credits should be somewhat higher, because during 2000–02 the equity market and the credit market experienced a high correlation.

Another way to benefit from bond floor convertible bonds is the basis play. Fixed income investors can buy the busted or bond floor convertible and underweight the straight bond in their portfolios, if the basis is too large compared to historical means or if the issuer exhibits a positive credit trend – then the basis usually decreases. As the
CDS recovers relative to the ASW level of the straight bond, investors earn an excess return. Two excellent examples were offered by the convertible bonds of France Telecom and those of the Dutch telecom provider KPN in the past. In the case of France Telecom, the holders of the convertible with a 4 percent coupon and 2005 maturity earned a 6 percent (not annualized) excess return over the straight bond with the same maturity from October 2002 until December 2002 as the basis declined between the CDS and the straight bond. The reasons were the announced debt-reduction measures of the company. In the case of KPN, the convertible issue is a subordinated one and investors could have gained both from the declining positive basis and from the melt-down of the subordination premium.

Busted convertibles have already lost their equity sensitivity, so the only way that the equity market could impact the price of the bond is, when the survival of the issuer is questioned or if the issuer just merged from a successful reorganization. In these cases the steep rise or decline in the equity price will impact the credit ratios and the refinancing opportunities of the company so the risk premium will be dramatically lower or higher as before. ABB is a good example. In 2002, ABB faced a distressed situation because of its asbestos liabilities, high short-term debt levels
and a poor earnings trend. The convertible bond with 2007 maturity traded as low as 40 percent of par in line with the straight bonds. After the successful restructuring plan of the company the spreads recovered along with the equity price, but the holders of the convertible bonds earned an extra return (almost 40 percent in 15 months) over the straight bonds because of the sharp increase in the equity price.

The price of the convertible bond will be positively influenced by a higher redemption price, because a higher redemption price means ceteris paribus a higher bond price. The coupon of the convertible bond could have an important role in measuring the composition of the total return of a portfolio. Many investors have tax restrictions or current income objectives on their portfolios so the tax impact of higher coupons (also in the case of exchangeable bonds the capital gains) and the sufficient current income generation potential of the portfolio are important issues to consider.

Prospectus: This factor is mentioned last not because of less importance but it is not a market factor. An indepth examination of the convertible bond prospectus is very important especially in the case of US and Asian  issues. Convertible bond investors have to be aware of a potential subordination of the issue, the diverse put or call structures and their impact on the price of the security. The dividend protection, the stock-split adjustments and the exchange rate impacts could present negative surprise for those investors without experience and reasonable care in investing in convertible bonds.

Like spread duration, the duration will also have an impact on the convertible bond as long as it is outstanding. This impact however depends on the equity sensitivity and maturity of the issue (also like in the case of the spread duration), the shorter the maturity and the less equity sensitive the issue is, the lower will be the reaction on any yield movement of the convertible bond. On the other hand, the implied equity volatility and the debt/equity ratio do not have any effect on the “normal” duration of the security.

Conversion price, stock dividend: These two factors have a very simple and straightforward effect on the convertible security. The higher the conversion price of the issue (option) relative to the actual market price of the shares for exchange the lower is the option value and with that the bond value. Stock dividends, if they are unexpected could adversely impact the near- or at-the-money option value, because they represent an opportunity cost for the holder of the option unless the issue prospectus effectively handles this problem.

Issuer credit risk impacts the price of the convertible bond throughout its whole life cycle. As we mentioned before, the credit risk will have a positive correlation to the implied equity volatility and to the share price of the issuer. The spread duration shows us the sensitivity of the convertible bond to the movements in the CDS levels of the issuer. The impact of the spread duration or in general the duration will decrease as the security moves up in the equity sensitive territory.

Convertible bonds are priced using CDS, so the holders of bond floor convertibles gain or loose versus the straight bonds because of movements in the basis (spread between CDS and the asset swap level of the bond). The following example shows the effect of the share price on the CDS (and implicitly on the value of the VNU 06 Convertible) in the case of VNU.