Lecture #13 Convertible Bonds

What are the 2 classifications of put options on convertible bonds?

1. hard put 2. soft put

the minimum price of a convertible bond is the greater of:

1. its conversion value 2. its value as a corporate bond without the conversion option-that is, based on the convertible bond's cash flows if not converted (i.e., a plain vanilla bond)

What are the advantages and disadvantages of issuing convertible bonds?

Advantages: -Companies can pay lower coupon rates on these bonds compared to non-convertibles (as investors find the conversion feature attractive). -Deductibility of interest (as compared to equity) Disadvantages: possible dilution of equity

Who is most likely to issue convertibles?

Companies with substandard credit ratings but high growth potential

protected call

The bond may only be called if the price of the underlying stock (or the average stock price over some number of days) exceeds a specified trigger price

conversion ratio

The number of shares of common stock that the bondholder will receive from exercising the call option of a convertible bond

physical settle

Upon conversion of a convertible bond, the bondholder typically receives from the issuer the underlying shares

convertible bond

a corporate bond with a call option to buy the common stock of the issuer

This standard type of call option in a convertible bond is called what?

an unprotected call

zero-coupon convertible bonds

are like any other bonds that pay no coupon interest

cash settle

cash settle

cash-pay/traditional convertible bonds

convertible bonds that pay coupon interest

mandatory convertible

is a convertible security that converts automatically at maturity into shares of the issuer's common stock. ->This automatic conversion differs from convertible bonds where conversion is optional

convertible preferred

is a preferred stock that can be converted into common stock

original issue discount (OID) convertible bond

is issued at a discount from par but has some coupon interest: the coupon interest rate is a below market rate

hard put

option in which the convertible security must be redeemed by the issuer only for cash

At the time of issuance of a convertible bond, the issuer has effectively granted what?

the bondholder the right to purchase the common stock at a price equal to: p = par value of convertible bond / conversion ratio -Along with the conversion privilege granted to the bondholder, most convertible bonds are callable at the option of the issuer as of a certain date

soft put

the issuer has the option to redeem the convertible security for cash, common stock, subordinated notes, or a combination of the three

straight value of a corporate bond

the lesser of either its conversion value or its value as a corporate bond without the conversion option-that is, based on the convertible bond's cash flows if not converted (i.e., a plain vanilla bond)

To estimate the straight value of a convertible bond, what must be determined?

the required yield on a nonconvertible bond with the same quality rating and similar investment characteristics -> Given this estimated required yield, the straight value in conventionally computed as the present value of the bond's cash flows using this yield to discount the cash flows

conversion value of a convertible bond

the value of the bond if it is converted immediately Conversion value = market price of a share of common stock × conversion ratio

contingent convertible bond

type of convertible bond that grants contingent conversion -> nicknamed a CoCo bond