Chapter 16: Convertible Bonds & Convertible Preferred Stock
Valuation of convertible bonds depends on
1) price of stock into which bond may be converted 2) value of bond as a debt instrument
PERCS are attractive to Investors who
1) seek additional div income 2) do not believe the price of CS will rise dramatically
Prices of Convertible Bonds fluctuate
1)periods of riding rates bc they have such small coupon rates 2) Value of underlying stock: declines-> price decrease
Convertible-exchanged preferred stock
2 Options: 1) holder may convert into common stock 2) company may force holder to exchange shares for firm's bond(give firm control)
Best outcome for PERC investor:
Price of stock to rise to max level only so they recieve higher div pmt & realize highest possible cap gain
MV of the convert bond will appreciate if
Price of the stock rises
Conversion ratio
- FV / Conversion price - determines amount of shares into which bond may be converted ex: $1000 bond @ $20/share = 50 shares
Contingent Convert Bonds "CoCo Bonds"
-becomes convertible IF price of the firm;s stock rises a specified amount from the date it was issued
Convertible Bonds
-debentures converted at the holder's option into the stock of the issuing company -LT: issued in $1,000 denom -pay semi ann -fixed maturity date
Price-ceiling on PERCS:
-if price of CS rises: PERCS price rises up to only the specific max price level - Price increases are offset by decline in number of shares when PERCS are exchanged
Convert Bonds: interest
-pay a lower interest rate -firms can issue lower quality debt at low cost
Put Bonds
-permits the holder to sell instrument back to the issuer at specific price and time -also have a call feature
Selecting Convertibles over Stock: is attractive when
-the additional income offsets the premium paid over the bond's value as stock in a moderate period of time (3-4) yrs
Once specific Price is reached on CoCo Bonds:
-the option to convert will last only 90 days
Convertible Bond as a Stock: Conversion Value depends on
1) FV/ principal amt of bond 2) conversion(exercise price) of bond 3) Market Price of common stock
2 considerations in calling bonds
1) Price of stock must exceed the exercise price of the bond 2) Actual timing of the call: almost always prior to interest payment
Selecting Convertibles over Stock: what's not mentioned
1) commission costs to buy bonds 2) Possible growth in div 3) time value of money
3 Possible outcomes for convertible bonds:
1) if stock rises: bond rise-> bond is converted 2) if firm defaults: bond is reissued as part of reorganization or becomes worthless 3) If value of stock does not rise: bond remains outstanding until issuing company retirees the debt
Conversion Price=
FV/ Conversion Rate
Reasons for Calling convertibles
Comp force to be converted to: 1)save the interest payments 2)makes balance sheets look better(less debt)
Preferred Convertible Stock: same but different
Differences: 1) treated as equity 2) may be perpetual 3) many have require sinking fund -> ALL are callable 4) tends to sell @ premium -> smaller premium bc its not debt
Convertible Bonds are Always callable:
Firms can force conversions -if called, owner must convert or any appreciation in price will be lost
Preferred Equity Redemption Cumulative Stock (PERCS)
P/S that WILL be exchanged in the future for the issuing firm's common stock -characteristics of preferred stock until converted -usually 3 yrs after issued
Arbitrage
Market price < bond's conversion value -sell it short
Hybrid Security
Market price of convertible bond is both: conversion value & value as a nonconvertible bonds
Put bonds: advantage
Protect bondholder from higher interest rates -> price of bond will decline
Time Value of Money
The premium paid in the present, but the flow of interest income occurs in the future
Convertible bondholders may only realize:
a fraction of the principal invested: in case of default or bankruptcy - still superior to stockholders
Maturity dates are irrelevant when
bond is converted into stock, retiring the bond
high stock prices: min price is set at
bond's value as a stock
Price of stock > exercise price
bond's value in terms of stock >principal amount
exercise price=market price of stock
bond's value in terms of stock= principal amount
PERCS: advtanges
higher yield: w/ PS than would have w/ CS
Holder risk
if company fails, holder of bond loses funds invested
Spreads b/w bid & ask price on Convert Bonds
larger than stock
Premium in terms of stock:
premium declines as price of stock rises
Premium in terms of nonconvertible bond:
premium rise as price of stock rise
Min price on convert bonds
price floor - gives investor safety that stocks lack -value in terms of stock or value as a nonconvertible bond
Premium > conversion value
suffer a loss
Number of shares X Market Price of a share =
the value of a bond in terms of stock ex: 50 shares , stock is selling for $15/share - bond is worth $750 in terms of stock
Debentures
uninsured debt instruments
low stock prices: min price is set at
value as a nonconvertible bond