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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. Convertible Bonds Primer 3 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. Convertible Bonds Primer 6 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 9 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 10 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. Convertible Bonds Primer 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. Convertible Bonds Primer 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 Convertible Bonds Primer 15 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. Convertible Bonds Primer 16 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. Convertible Bonds Primer 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. Convertible Bonds Primer 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. Convertible Bonds Primer 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