Practice investment management pim3 ch14
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CHAPTER FOURTEEN
CONVERTIBLE SECURITIES
Practical Investment Management
Robert A. Strong
Outline
Convertible Bonds
Characteristics
Pricing of Convertible Bonds
Why Companies Issue Convertible Bonds
Unusual Features
Convertible Preferred Stock
Background on Preferred Stock
The Conversion Feature
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Outline
Warrants
Characteristics
Pricing of Warrants
Warrants and Leverage
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Convertible Bonds: Characteristics
Convertible bonds give their owner the right
to exchange the bonds for a set quantity of
some other asset. This other asset is
normally shares of stock in the same
company.
The number of shares the bondholder
receives per $1,000 par value when
converting the bond is called the conversion
ratio.
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Convertible Bonds: Characteristics
par value
conversion price =
conversion ratio
conversion
conversion
current
=
X stock price
value
ratio
premium over
market
conversion
conversion value = price value
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Pricing of Convertible Bonds
Insert Table 14-1 here.
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Pricing of Convertible Bonds
Over time, a convertible bond will
increasingly act like a share of stock or like a
non-convertible bond.
A bond whose conversion price is
substantially above the current market price
of the associated common stock is a busted
convertible.
A convertible in a company whose stock has
appreciated is an example of a common
stock equivalent.
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Metamorphosis of a Convertible Bond
Acts like a Stock
stock price
conversion price
new
convertible
bond
common
stock
equivalent
rising stock price
declining or slow
rising stock price
time
busted
convertible
Acts like a Bond
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Pricing of Convertible Bonds
Convertible bonds should never sell for less
than their conversion value.
With a busted convertible, the conversion
feature has little value.
Convertible bonds provide for upside
potential while reducing downside risk.
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Pricing of Convertible Bonds
Insert Table 14-2 here.
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Pricing of Convertible Bonds
The premium payback period is the time
required for the enhanced income from the
bond (relative to the equivalent number of
stock shares) to offset the premium over the
conversion value.
The premium payback period is sometimes
called the break-even time.
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Calculating Premium Payback Period
market conversion price =
market value
conversion ratio
Premium payback period =
market conversion price - stock price
bond interest - ( conversion ratio × dividends per share )
conversion ratio
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Why Companies Issue Convertible Bonds
Convertible bonds can usually be offered at a
lower interest rate than would otherwise be
required.
All convertible bonds are callable. If called, a
convertible bond must be (1)sold,
(2)redeemed, or (3)converted.
Corporations like to issue convertible bonds
because of the likelihood that they will never
have to repay the debt.
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Convertible Bonds: Unusual Features
Interest payments: A few convertible bonds
do not pay interest twice a year, but monthly
or quarterly, for example.
Underlying asset: Many convertible bonds
are convertible into the securities of another
company. Some are convertible into cash.
LYONs: Many companies issue zero coupon
bonds, or liquid yield option notes (LYONs).
A number of these are convertible into
the company’s common stock.
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Convertible Preferred Stock
Preferred stock is attractive to corporations
because of the tax-exempt nature of most
dividend income.
From an investment perspective, preferred
stock is a fixed income security.
Preferred stock is identified by its annual
dividend.
The fundamentals of conversion are the same
as those for convertible bonds.
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Warrants: Characteristics
A warrant is a nondividend-paying security
giving its owner the right to buy a certain
number of shares at a set price directly from
the issuing company.
Warrants have no voting rights.
Outside the United States, warrants are often
issued in conjunction with a new debt issue,
thus enabling a lower interest rate than
would otherwise be required on the issue.
Warrants can be detachable or
non-detachable.
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Pricing of Warrants
The exercise price is the price at which an
investor holding warrants may buy the
underlying shares.
When the stock price rises above the
exercise price, the warrant is in-the-money,
and has intrinsic value.
If the stock price is below the exercise price,
the warrant is out-of-the-money.
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warrant price
Pricing of Warrants
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(=
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ax
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45º
45º
exercise price
stock price
Assumption:
One warrant is required to buy one share of stock.
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Warrants and Leverage
Speculators buy warrants because of the
leverage they provide.
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Review
Convertible Bonds
Characteristics
Pricing of Convertible Bonds
Why Companies Issue Convertible Bonds
Unusual Features
Convertible Preferred Stock
Background on Preferred Stock
The Conversion Feature
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Review
Warrants
Characteristics
Pricing of Warrants
Warrants and Leverage
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