Download Convertible Bonds Primer

Convertible
Bonds Primer
Last Updated: July 29, 2004
Table of Contents
Introduction
3
Convertible Bond Issuers
3
How Clients Can Benefit From Convertibles
4
Equity Alternative
4
Fixed Income Alternative
5
Currency Play
6
Understanding The Prospectus
6
Convertible Mechanics
9
Types of Convertibles
13
Evaluating Convertibles
14
Selecting Convertibles
17
Glossary
19
Convertible Bonds Primer
2
When investors are first approached with the idea of investing in convertibles,
they often get the feeling that they’re “too good to be true.” Convertibles provide
the best of both worlds: fixed income yields with stock market participation. If
you are a fixed income investor; they can provide you with a hedge against rising
interest rates or a higher rate of total yield. If you are approaching convertibles
from an equity perspective, they can award you downside protection and a yield
advantage. Valuable in many market climates, they are an appropriate
investment for long-term investors seeking higher rates of total return but with a
reduced risk complexion.
Introduction
Convertible debentures are hybrid securities, which combine the characteristics of
fixed income and equity. The owner of a convertible has the right to exchange it
for a predetermined number of shares during a specified period of time. Like a
bond, convertibles generally guarantee a specified interest payment and a par
value, usually $1,000, at maturity. The one important feature that differentiates
convertibles from bonds is that the holder has the option to convert the bonds
into equities at their prerogative. This feature completely alters the valuation and
payoff of the bond. The basic attraction of a convertible lies in its ability to pay
interest while participating in the capital appreciation of the underlying stock.
Convertibles have become a mainstream asset class as the investment
community has come to realize their usefulness at many points along the market
cycle. In the past, investors have generally overlooked convertibles because they
have not been widely followed in the financial news and their perceived
complexity has caused investors to ignore their merits and diversification
characteristics.
Ideally, investors in a convertible bond look to earn two-thirds of the upside
return while limiting themselves to only one-third of the downside risk.
Convertible Bond Issuers
There are four main scenarios under which convertible bonds are issued.
The first is by companies as a means of deferred equity financing. If a company
believes that its present share price is too low to issue common shares, they can
issue convertibles with a conversion price above the current stock price. The firm
also benefits from interest savings, as interest costs are generally lower than
those of straight debt, and the tax-deductibility of the interest expense over that
of after-tax dividends.
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Small, fast-growing companies wishing to minimize their interest cost will issue
convertible bonds. These companies often have volatile capital structures and
usually lack a long-term track record. For these reasons, they are required to
raise debt at a significantly high interest cost. By issuing convertibles, they are
able to both harness the volatility of their capital structure and reduce the
interest payments on their debt. In most cases, the higher volatility translates
into a lower coupon. This form of financing is also appropriate for these firms
because as the stock price grows, the company will likely convert the bonds to
equity, thus strengthening the company’s balance sheet.
Mature companies will issue convertible debt because of the favourable terms
under which they can be issued. The relatively lower interest payments and
higher premium allow them to further decrease their cost of financing and
improve their overall returns.
The final scenario under which firms employ convertible debentures is to
monetize non-strategic assets. If an asset is sold to another company, the
purchaser may offer a quantity of stock instead of cash. The firm receiving the
stock can monetize the asset by issuing a convertible (generally termed
“exchangeable debentures”). This not only allows the company to receive cash
immediately for the asset, but it also allows it to defer any taxes owing on the
sale of the stock.
How Clients Can Benefit From Convertibles
Investing requires a continual search for ways to control risk and protect assets
while attempting to achieve above-average returns. As investor demands grow,
they will no longer be satisfied with the traditional mix of stocks and bonds. By
including convertibles in a client’s portfolio, you can increase the return per unit
of risk while further diversifying their holdings.
The relationship between equity and fixed income within a convertible can be
described as non-linear in nature. For that reason, simply combining bonds and
equities cannot duplicate the convex relationship inside of a convertible.
Convertibles should be viewed as a separate asset class but they are generally
employed as a surrogate for either the equity or fixed income class with an
altered risk/return complexion.
Equity Alternative
Investing in convertible bonds can offer clients numerous advantages over
investing in common stock. As holders of a more senior security, investors have a
Convertible Bonds Primer
4
greater claim on the firm’s assets in the event of insolvency. The investor’s
income flow is also generally higher and more stable since coupon payments are
normally higher than the dividend yield and are a contractual obligation. As well,
convertible bonds offer both protection in bear markets through the regular bond
features and participation in capital appreciation in bull markets through the
conversion option. In comparing the return of the convertible to that of the
equity, the investor should consider the total return presented by both
investments. The equity’s total return comprises of its capital appreciation and
dividend income, while a convertible’s is a function of the change in conversion
value, the change in premium levels, interest income, and its put feature.
Investors who believe that a downturn in the market may be approaching could
protect themselves by swapping into a convertible bond to maintain their equity
exposure but minimize their downside risk.
Convertible securities can be considered defensive alternatives to their underlying
equity. Income-oriented equity investors can participate in low-yielding equities’
price appreciation through convertible securities. Convertibles trading at a
premium increase in value at a slower rate than the underlying equity. The
investor is willing to forfeit some equity upside potential for the yield and
protection.
Investing in small-cap stocks has often been a very lucrative but risky strategy.
Many academic studies have shown that small-caps have produced superior
returns over larger companies. By employing their convertibles over the direct
equity, investors can reduce risk while still providing a means to participate in
their superior upside. However, investors should be prepared to monitor these
convertibles very closely given their high level of volatility. As well, the liquidity
of these issues can be very poor.
Fixed Income Alternative
Convertibles are particularly attractive as an alternative to straight bonds
because of their conversion feature. By choosing convertibles over straight
bonds, investors have the opportunity to generate higher returns and potentially
provide themselves with some protection against interest rate risk. If straight
bond yields are low, convertibles can be used to increase total return through the
incremental returns generated by their equity participation. Although convertibles
will be issued with a lower coupon payment to straight debt, the potential for an
overall higher total return exists.
To a bond investor, a convertible can be used as an equity bull market vehicle.
When a portfolio is prohibited from investments in equities, convertibles can
provide a source of equity market participation. As a bond surrogate, one of a
convertible’s main advantages is that it can provide an inflation hedge through its
Convertible Bonds Primer
5
equity participation. Even minimal equity influence can translate into an
increased total return over time.
Investors should understand that they do pay a price to participate in the equity
fluctuations. Convertibles are a riskier alternative to bonds and are usually
subordinate to other bonds in the capital structure. In the event of bankruptcy or
corporate reorganization, convertible debenture holders rarely are treated as well
as the holders of the corporation’s more senior debt issuers, and in some cases
receive no more than the common shareholders. Investors should also keep in
mind that the credit quality of convertibles relative to straight bonds can be
difficult to judge. This is because convertible issuers rarely pay the cost of having
their bonds rated by S&P, Moody’s, CBRS or DBRS.
Currency Play
Convertibles can provide an investor with currency exposure. Convertible
securities denominated in foreign currencies or convertible into foreign equity
provide the investor with the opportunity to participate in the fluctuations of the
underlying currency. In both cases, the convertible’s value is determined not only
by the interplay of the debt and equity components, but also by the fluctuations
in its currency. Convertibles are widely issued in all markets around the world.
Understanding the Prospectus
A convertible’s features and privileges are detailed in its indenture (or final
prospectus). It is a legal document that discloses all the specifics about the
convertible, its underlying equity, and the issuer.
The cover page will summarize all of the most pertinent information about the
issue. Although the main features of the convertible are laid out in the cover
page, it is highly advised that the investor thoroughly read the prospectus or
indenture in order to understand the specifics of the issue. Within the body of the
indenture, the convertible’s features are described in full. It is particularly
important to read this information because features vary among issues, and new
structures are continually evolving. We highlight some of the most important
features next.
Call Protection – This feature describes the duration of the protection that the
holder has from having the issuer call the bonds. Soft-call provisions, which are
call features requiring a specific hurdle rate to be met before calling the bonds,
are becoming more prevalent. For an investor, hard-call protection with a long
duration is the most desirable.
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Conditional Income – Investors should be wary of conditional income
stipulations. Under these terms, the issuer will pay dividends or coupons only on
the condition that cash is available to fund them. Although rare, investors should
be mindful of their rights in the case of default.
Convertibility – Immediate and continuous convertibility is advantageous over
limited (or European style). In the case of a takeover or any activity that can
increase share value, the convertible holder with limited convertibility may not be
able to participate in the appreciation.
Dilution Protection – Holders of convertibles are not compensated when normal
dividends are distributed. Under the scenario that a company makes an
extraordinary dividend payment, convertible investors will want to be
compensated. The indenture will outline whether the convertible qualifies for
extraordinary distributions, in order to protect against dilution.
Ranking – Investors should be conscious of where they rank in the capital
structure. Obviously, investors favour the most senior ranking in case of financial
distress. When investing in convertibles, investors should look for crosscovenants with the company’s other debt obligations to ensure an equal level of
protection.
Ranking Shares – When convertibles are exchanged for shares, they usually
rank for the next payable dividend. However, in some countries, dividends
declared for one fiscal year are not payable until the following year. For that
reason, investors who convert their bonds towards the end of the year may not
only lose the accrued interest but will have to wait until the following year to
qualify for the dividend. The investor should make sure that they rank for the
next payable dividend if converted.
Redemption Terms (Cash or Stock) – Issuers are increasingly given the
opportunity to redeem the bonds in either stock or cash. Ideally, the two values
should be equivalent, but investors should prefer cash because of the potential
slippage in stock price as bondholders simultaneously sell stock to obtain cash.
Sleeping Investor Clause – If the current stock price is above the redemption
price at maturity, a rational investor would convert into stock. A sleeping investor
clause permits the trustee to convert the bond, if it is to the investor’s
advantage, and the investor has not responded to the action notification.
Takeover Protection – If a change of control is to take place the convertible
owner may be placed at a disadvantage. The investor usually pays a premium to
hold a convertible security and requires time to earn a yield advantage. A
takeover can shorten the investor’s holding period and robs them of this ability.
Convertible Bonds Primer
7
In order to protect themselves, investors whose bonds are trading at a discount
should look for a put-at-par feature. The other option is an adjustment to the
conversion ratio, which would bring it in line with the average pre-announcement
level.
What to look for in a Prospectus
Favourable
Unfavourable
Long period of call protection
Callability soon after launch
Dilution protection
Protection only against basic issues
Compensation for extraordinary
events such as special dividends
No mention of bondholder
compensation if equity bonus
Ranking shares upon conversion
Converted shares to not rank for the
dividend for the first financial year
Sleeping investor clauses
Investor must remember to convert if
in his or her interest
Immediate and continuous
convertibility
Limited convertibility, or cash
alternative
Senior or unsubordinated
Subordinated
Protection in the event of change in
control
No reference to change of control
Cross-covenants
No reference to other debt
Weak redemption structure
Straightforward redemption
Nonpayment of coupon/dividend
would constitute a default
Conditional income
Adequate default protection
Little default protection
Accrued interest paid out when
converted
Accrued interest forfeited when
converted
Interest payable in cash
Interest payable in cash or shares
Convertible Bonds Primer
8
Convertible Mechanics
Convertible bonds are issued with set interest payments and a maturity date.
When the bonds mature, they are generally redeemed at their face amount
($1,000). The coupon is the stated rate of interest paid to the holder of the bond
by the issuing company. It is generally paid on a semi-annual basis but will
periodically appear on an annual basis. Interest payments are calculated off of
the face value.
For example, if Canada Co. issues semi-annual 8% coupon bonds, it will pay $40
per $1,000 every six months.
Semi-Annual Interest
Payment
= (Coupon Rate / 2) x Face Value
= (8.00% / 2) x $1,000
= $40
Accrued interest is the amount of interest that has accumulated since the last
interest payment. It is calculated by multiplying the number of days elapsed
since the last coupon payment, times the daily interest rate. Be cautious of the
bond’s nationality when calculating accrued interest, Canadian bonds calculate
interest on a 365-day calendar while American bonds are calculated on a 360-day
calendar.
Canadian Accrued Interest
Coupon Per Bond
= (Days since last coupon / 365 Days) *Ann.
U.S. Accrued Interest
Coupon Per Bond
= (Days since last coupon / 360 Days) *Ann.
The investor has the right to exchange the convertible bond for a specified
number of shares within a given period of time. At issue, the company
establishes a conversion price from which the conversion ratio can be calculated.
The conversion ratio is the number of shares for which the convertible can be
exchanged per bond. It is calculated by dividing the bond’s face amount by the
conversion price. To continue on with our example, Canada Co. issues its
convertible with a face value of $1,000 and a $125 conversion price.
Conversion Ratio
= Bond Denomination / Conversion Price
= $1,000 / $125
= 8 Shares
Parity or intrinsic value is the price at which the convertible security must trade
to be equivalent to the market value of the equity received upon conversion. It
Convertible Bonds Primer
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establishes a minimum boundary condition for the price of the convertible. It is
usually expressed as a percentage of par and is calculated by multiplying the
current market price by the conversion ratio. In our example, we will assume that
the current share price for Canada Co. is $100 per share.
Parity
= Conversion Ratio * Current Share Price
= 8 * $100
= $800 or 80%
Since the bond is more secure and generally pays a higher interest rate than the
underlying dividend payment, investors are willing to pay an extra amount in
order to own the convertible over the underlying stock. Called the conversion
premium, it is the difference between the market price and the conversion price,
and is expressed as a percentage. We will assume that the current market price
of the convertible is $1,185.
Conversion Premium
= (Market Price – Parity Price) / Parity Price
= ($1,185 - $800) / $800
= 48.13%
This can be read as: the investor is willing to pay a 48.13% premium in order to
have the bond features available over the equivalent number of equities. The
market forces are what determine the premium that exists on the convertible in
the marketplace. As the underlying stock increases in value above par, the
conversion premium will shrink until the market price and conversion price are
equal.
A convertible’s investment value is its price if it were valued as a regular straight
bond. It is determined by calculating the present value of the coupons and the
return of principal at maturity. If the underlying stock falls such that the
conversion privilege becomes worthless, the convertible will trade solely on its
fixed income characteristics. The investment value is then impervious to
movements in the share price until such point that the credit quality is
compromised. The investment value premium is the difference between the
market price of the convertible and its investment value. Similar to the
conversion premium, it is also expressed as a percentage. Assuming that the
investment value of the Canada Co. bond is $847,
Investment Premium
= (Market Price – Investment Price) / Investment Price
= ($1,185 - $847) / $847
= 39.9%
The investment premium describes the value of the opportunity to participate in
the equity upside of the bond over its straight bond equivalent. A convertible with
Convertible Bonds Primer
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a small investment premium will be heavily influenced by movements in interest
rates and minimally impacted by a shifting stock value. Alternatively, a high
investment premium indicates that the convertible is an equity surrogate and has
less downside protection.
When evaluating a convertible from its fixed income perspective, its yield-tomaturity should be examined. The yield-to-maturity is the rate of return
anticipated on a bond if it is held until its maturity date. In order to calculate
yield-to-maturity, you must use a financial calculator and possess the current
market price, par value, the coupon and time to maturity. The calculated yield
assumes that all coupons are reinvested at the same rate.
The current yield of the bond is calculated by dividing the bond’s coupon by its
current value. It ignores any premium or discount on the bond and is a static
view of the return offered by the convertible.
Current Yield
= Coupon / Market Price
= 8.00% / $1,185
= 6.75%
Convertibles will generally offer a current income advantage over the dividend
yield of the underlying equity. To calculate the yield advantage, the dividend
yield on the underlying equity is subtracted from the current yield of the bond.
Assume that Canada Co. pays a $1.00 annual dividend.
Yield Advantage
= Current Yield – Dividend Yield
= 6.75% - 1.00%
= 5.75%
Convertible investors pay a premium to hold the convertible over the underlying
equity. The investor will recoup the premium over time by the yield advantage
that the coupon offers over the dividend. Break-even analysis calculates the
amount of time (in years) that a convertible investor must hold the convertible in
order to recapture the premium.
Break-even Period
= Conversion Premium / Yield Advantage
= 48.13 / 5.75
= 8.37
The investor will have to hold the convertible for 8.37 years in order to break
even on premium paid.
A truer method of break-even or payback analysis is the cash-flow method.
Under the cash-flow calculation, the investor compares the premium paid for the
Convertible Bonds Primer
11
bond to the difference in dollar values between the interest on the bond and the
dividend payments on equivalent underlying equities. In our example, the
Canada Co. convertible is paying $80 in interest annually, while the underlying
eight equity shares are paying $1 each.
Break-even Cash Flow = Conversion Premium / Dollar Difference
= ($1,185 – $800) / ($80 - $8)
= 5.347
In this case, the investor must hold the convertible for 5.35 years in order to
recoup the premium paid. It should be noted that different styles of break-even
analysis yield different results and do not take tax-treatment into consideration.
The redemption of convertible securities can take place on a mandatory basis
(issuer redeems) or a voluntary basis (investor redeems). A mandatory
redemption will take place through a call feature or a sinking fund. The call
feature allows the issuer to redeem the bonds prior to maturity at a specified
price, usually above par. The call price will be higher in the earlier years and fall
towards par with the passage of time. An example of a call feature would be that
the convertible security cannot be called for five years from issuance unless the
stock price exceeds 125% of the conversion price for 30 consecutive days. A
sinking fund establishes a schedule of redemption at preset prices regardless of
the current price of the convertible. The terms of both the call feature and the
sinking fund will be specified in the indenture.
The investor can voluntarily redeem the bonds through a put feature. The put
feature is the investor’s right to sell the bonds back to the issuer at a
predetermined price. The put feature is generally continuous and imposes few
restrictions on the investor. It is a very uncommon feature outside of its use in
the case of a change of control.
After a convertible is issued, its price will change depending on the relationship
between the stock price and the conversion price. The relationship can be
described as either butane, balanced or busted.
A “butane” convertible, also described as in-the-money, is when the stock price
exceeds the conversion price. As the stock price rises, the convertible becomes
more sensitive to changes in the stock price and less so to changes in interest
rates. The conversion premium will fall as the parity increases with the stock
price. The investment premium will grow as the convertible trades more like
equity and offers little downside protection.
Convertible Bonds Primer
12
The convertible is considered “balanced” when the stock price is close to the
conversion price. When balanced, the convertible’s price is being influenced by
both interest rates and the underlying stock price.
A convertible is “busted” or out-of-the-money when the stock price is less than
the conversion price. At this point, the bond’s price is primarily a function of
interest rates and credit factors. As the stock price declines, the convertible price
follows suit but at a reduced rate. If the credit becomes distressed, the
investment value will break down and the convertible will trade like junk.
Types of Convertibles
There are many different structures that convertible bonds can take. The most
common is issued at par, matures at par, and pays semi-annual interest. The
only difference that it has from a straight bond is that the coupon is lower and it
can be exchanged for stock. Other structures do exist but they are less common.
They include:
Adjustable Rate Convertibles – This type of convertible may have an interest
rate or dividend, which is adjusted periodically, usually based on a standard
market rate such as that on existing Treasury bonds or notes. These issues
usually have floors and ceilings, which limit their adjustments.
Convertible Preferred Stock – This style of convertible pays a fixed dividend
and is convertible into the underlying common stock. Convertible preferred stock
differs from regular convertible bonds in that the dividend can be deferred at the
company’s request without triggering default. Convertible preferred stock ranks
above common in dividend priority and is treated like equity by rating agencies.
Convertible Stock Notes – They are often referred to as Pay-In-Kind (PIK). The
issuer has the option to pay the interest and principal in either cash or stock.
Companies in financial distress usually issue this structure of note because it
allows them to manage their cash flow.
Exchangeable Convertibles – This type of convertible is issued by one
company with the shares of another company as the underlying. These
convertibles are usually created to monetize a non-strategic asset in a taxefficient manner. An issuer who issues exchangeable convertibles is able to
receive the proceeds of the sale of the stock immediately while shielding
themselves from capital gains until the bonds are actually converted sometime in
the future.
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13
Exchangeable Convertible Preferred – The convertible gives the issuer the
option to exchange its existing convertible preferred for a convertible bond. The
terms of the exchange will be included in the indenture when originally issued.
The reason why such instruments exist is to afford the issuer some flexibility in
the balance sheet. In exchanging the convertible preferred for the convertible
bonds, the issuer is able to substitute a non-tax deductible item for one that is.
Mandatory Convertible Securities (MCS) – These convertibles are the most
equity-like of the varying types of convertibles. They are converted into a fixed
amount of equity at maturity and should be considered yield-enhanced common
stock. They offer limited downside protection other than their higher yield, since
at maturity the value of the shares received can be less than the par amount of
the debenture.
Puttable Convertible Bonds – This structure permits the holder of the bond to
sell it back to the issuer at par or a premium above par prior to maturity. The put
dates can range in frequency and price above par, but they will always come due
prior to maturity. The put is included in order to shorten the maturity of the bond
and raise the investment value. Put features are usually included by issuers who
have a high level of volatility because the investors demand downside protection.
Zero-Coupon Convertible Bonds (OID) – This type of convertible pays no
coupon and is issued at a deep discount to par. It has a positive yield to maturity
and accretes towards par over its life. The bonds are usually issued with low
conversion premiums since the conversion price moves away from the investor as
it accretes.
Other features that investors should watch for are whether the bonds are
resettable or provide premium protection. Resettable bonds allow the adjustment
of the coupon, conversion ratio, conversion price or maturity date, if a specified
situation arises. The resettable feature allows the bond to maintain its value in
extraordinary situations. Premium protection is offered on convertibles with no
call protection. If the bond is called early, the premium protection allows the
holder of the bond to continue to receive a portion of the coupon payments
during the call-protection period. By having this stipulation, the value of the
initial premium paid by the investor at issue is preserved.
Evaluating Convertibles
When evaluating a convertible, the investor must take both the equity and debt
features into consideration.
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14
The debt component should be evaluated based upon the financial quality, the
current interest rate environment, and the convertible’s features. Changes in the
fundamentals of a company will have an immediate effect on the bond
investment value. Monitoring the fundamentals when evaluating convertibles is
essential to ensuring that an investor is not disadvantaging him/herself. When
evaluating the fundamentals of a company, the investor should look at:
1. Financial Considerations – conservativeness of accounting practices,
financial goals and policies of the company
2. Financial Ratios – debt to equity, interest coverage ratios, operating
income to sales, equity turnover, net income to total assets, working
capital to total debt, debt in payback period and total debt as percent of
capital
3. Industry Risk – competitiveness, growth, government regulations, cost
factors, operating coverage, cyclical nature of the business and the issuer’s
position within the industry
4. Management Considerations – operating track record, changes in key
personnel, depth of management, cost-control effectiveness,
innovativeness and labour relations
5. Profitability Ratios – return on equity, profit margins, earnings growth,
coefficient of variations for return on earnings and coefficient of variation
for earnings per share
6. Other Considerations – issue size, subordination of the issue, size of the
firm, financial flexibility, future capital needs and product diversification
The investment value over the long term does fluctuate over time, but it must
increase to par value by the time the bond matures. Therefore, as time passes,
the investment value gradually rises to par regardless of how the common stock
is performing. The investment value will be impacted by changes in the interest
rates in the short term, so when interest rates increase (decrease) the
convertible’s investment value will fall (rise). Being conscious of the interest rate
forecast will aid in determining how the investment value will fluctuate.
The investment value can also be evaluated alongside similar company debt. By
considering the credit spread and the term to maturity, the investor can closely
approximate the investment value of the convertible. The investment value
should also fluctuate in tandem with the yield to maturity of straight corporate
bonds that are similar in quality. If the company doesn’t issue debt or an
equivalent bond doesn’t exist, the investor can estimate the bond’s investment
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value by calculating its present value. A discount rate can be assumed from an
equally termed government bond plus a credit spread for risk.
Convertible bonds trading high above their investment value will be less sensitive
to interest rates than those trading closer. It is best to evaluate the sensitivity of
a convertible to changes in interest rates. The easiest method to do this is by
calculating the bond’s duration. Duration analysis takes into consideration the
coupon rate and maturity date of the bond, and time-weights its cash flows.
Although these factors can influence the investment value of the convertible
bond, the market price may not always be affected. Changes in interest rates or
credit quality are just a couple of the factors that are affecting the convertible’s
value. The convertible is also being driven by its equity component.
The convertible’s equity component should be valued according to the analyst’s
opinion of the company, the risk measures of the common stock and how much
equity participation the convertible currently exhibits.
The analyst’s opinion of the company is a good source of evaluation. The investor
should be looking at the company’s rating, its short and long-term prospects and
its market fundamentals.
Investors should keep in mind that volatility can be looked upon favourably by
the convertible market. Examining the equity’s standard deviation and beta will
provide the investor with a gauge of its volatility.
The conversion ratio is an indication of the leverage of the convertible bond. A
convertible with a larger conversion ratio will fluctuate more for a given move in
the underlying equity.
The equity component should be viewed as a call option on the underlying equity.
The convertible holder has the option to call the equity from the issuer for a
specific time period at a preset price. It should be evaluated using an option or a
long-term warrant model. Unfortunately, these models are very sophisticated and
there is not a simple estimate. It is suggested that the investor conduct
additional study into these valuation estimates in order to properly understand all
of their nuances.
Once the option and investment value have been calculated, their values are
combined to form a theoretical price. The value is commonly estimated by adding
the two values together, but a true estimate is not so simply attained. Calculating
the covariance between the interest rate and the underlying equity price will
determine the appropriate weightings for each to the theoretical price.
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The bond-plus-option method is one of the few attempts that exist to value the
hybrid nature of convertibles. It is a time-consuming process, which is generally
only carried out by convertible analysts.
One last measure that investors should keep in mind when looking at convertible
valuations is that fluctuations in the short term are random occurrences and are
nearly impossible to predict. Over the medium to long term, the economic
principles underlying the security should take hold and influence the trend in
prices.
Selecting Convertibles
Due to their hybrid nature, convertibles are considered to be both bull and bear
market instruments. In bull markets, convertibles have generally trailed global
equities by only a few percentage points, while in bear markets, convertibles can
offer significant downside support relative to equities. The first step in selecting
convertible debentures is to understand your reason for purchasing them. There
are many different strategies for owning convertibles, four of which are listed
below.
1. Diversifying your fixed income portfolio
2. Increasing the total return of your fixed income portfolio
3. Adding downside protection to your equity exposure
4. Increasing the total return of your equity
The next step is to ensure that you do your homework on the underlying equity
and any related debt. If there is no compelling reason to own the company, there
is no reason to own the convertible. Reading through the analyst coverage of the
underlying equity will provide some direction as to whether the company is
worthwhile. Be sure to evaluate the convertible based upon techniques outlined
in the previous section. An evaluation of the investment and option value should
be performed. Once a theoretical value has been calculated, evaluate it against
the market price and make an investment decision.
Many investors who are new to convertibles don’t realize that it is not necessary
to convert to the underlying common stock to realize a profit. The market price of
a convertible varies with changes in the stock price, so the bond can be sold
anytime the holder desires and generate a profit.
The following table lists the qualities of a convertible that an investor would look
for under each of the strategies listed earlier.
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17
Diversify Fixed
Income
Portfolio
Increase Total
Return of Fixed
Income Portfolio
Adding Downside
Protection to
Equity Exposure
Increase Total
Return of Equity
Portfolio
• Convertibles
• Convertibles with
• Convertibles with
• Convertibles with
with large caps
underlying
• Trading mildly
out-of-themoney to atthe-money
• Senior or
large caps
underlying
• Trading at-the-
money
(balanced)
large caps
underlying
• Trading at-the-
money
(balanced)
• Trading in-the-
money (butane)
• High coupons
• Senior or
• Put-feature on
• Cross-covenants
• Accrued paid if
unsubordinated
the bond
payments
• Underlying equity
unsubordinated
• Cross-
covenants
small-cap
underlying equity
converted
• Adequate default
protection
• Adequate
has a high price
target
• Dilution
protection
default
protection
• Continuous
convertibility
• Long call
protection
• Accrued paid if
converted
Convertible Bonds Primer
18
Glossary
Accrued Interest – The amount of interest that has accrued to the bondholder
since the last coupon payment.
Arbitrage – Simultaneous purchase and sale of securities to take advantage of
pricing inefficiencies created by the market.
At-The-Money – When the underlying stock price is close to the conversion
price.
Break-even Period – The time period, in years, over which the convertible
recaptures any premium paid over conversion value by virtue of the yield
advantage.
Busted Convertible – A convertible in which the equity has substantially
declined below the conversion price and is selling essentially as a straight bond.
Call Option – The right, but not the obligation, to purchase a security at a
specified price for a predetermined period of time. No dilution.
Call Price – The price an issuer agrees to pay an investor in the event the
convertible is called.
Call Protection – Ensures that the issuer cannot call the bond away from the
investor. There are two types: hard and soft.
Callable – Term applying to convertible securities that contain a provision giving
the issuer the right to retire the convertible prior to its redemption date.
Conversion Parity – The value of the shares of the underlying common stock
into which the convertible can be exchanged.
Conversion Premium – The difference between the convertible’s price and
parity, expressed as a percentage of parity.
Conversion Price – The share price at which the convertible can be exchanged
for shares upon conversion.
Conversion Ratio – The number of shares of stock into which each convertible
can be converted.
Convertible Bonds – Debt securities issued by a company that are convertible
at the investor’s option into the common stock of that company.
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19
Convertible Preferred – Preferred shares issued by a company that are
convertible at the investor’s option into the common stock of that company.
Convertible Security – A bond or preferred stock that can be exchanged or
converted into the common stock of a company.
Coupon Rate – The annual interest payment received from a bond.
Current Yield – The bond’s annual coupon expressed as a percentage of the
market value of the convertible security.
Dilution – The increase in the total number of shares outstanding due to the
issuance of new shares, or the conversion of existing warrants or convertibles.
Exercise Price – Price at which the underlying stock is delivered in the event an
option is exercised.
Exchangeable – A convertible issued by a company that is convertible into
shares of another company.
Hard Call Protection – Period during which the issuer cannot call the bond
under any circumstances.
Hedge – A position whose specific intent is to neutralize the price risk of an
existing position.
In-The-Money – When the price of the underlying stock exceeds the conversion
price.
Investment Premium – The difference between the convertible’s price and its
investment value, usually expressed as a percentage.
Investment Value – The value of the straight fixed-income element of the
convertible, without regard to its embedded equity option.
Mandatory Convertible – A convertible security in which the holder is obligated
to convert into the underlying equity at maturity.
Option – The right to purchase or sell an asset or security at a predetermined
price for a set period of time.
Out-Of-The-Money – When the stock price is less than the conversion price.
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20
Put Feature – The bondholder’s privilege to force early conversion.
Put Option – The right, but not the obligation, to sell a security at a specified
price for a predetermined period of time.
Short Selling – Selling borrowed shares of a common stock.
Soft Call Protection – The issuer has the right to call the convertible under
certain circumstances, for example, if the underlying stock trades at a price that
exceeds the conversion price for a set period of time.
Volatility – The degree to which the price of a security tends to fluctuate over
time.
Warrant – A long-term right to buy or sell a certain number of shares at a
predetermined price for a specific period of time. Dilution is created.
Yield Advantage – The difference between a convertible’s current yield and the
underlying stock’s dividend yield.
Yield to Maturity – The bond’s internal rate of return to the call date.
Zero-Coupon – A bond that pays no coupon and is usually issued at a deep
discount to par.
Convertible Bonds Primer
21