Chapter 20: Analysis of Convertible bonds

Another convertible that was at one time issued for its favorable tax treatment is one with contingent payment provision, nicknamed

"CoPa" bonds

favorable income differential per share is equal to

(coupon rate x par value) - (conversion ratio x dividend per share) / conversion ratio

Former Lehman brothers started publishing the Lehman US Convertible Indices

(replaced by more recent indexes)

Unlike a traditional convertible bond whose coupon rate is fixed over the bonds life, a CoPa bond pays higher coupon rate if the price of the underlying stock price reaches a specified threshold

(say 125% of the conversion price)

The different subindexes of the four indices shown below indicate the different subsectors or ways to categorize the convertible bond market

-Type -Credit Quality -Underlying Market Capitalization -Profile

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 bonds cash flows if not converted (i.e, a plain vanilla bond) -This latter value is called its straight value

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

Convertible bond

Illustration

Example

Illustration

Example slide

illustration continued

Example slide with explanation

grants the bond holder the right to exchange the bonds for the common stock of a firm other than the issuer of the bond

Exchangeable bond

Basic Analytics and Concepts for Convertible Bond Analysis

Minimum Value of A Convertible Bond (slide)

Some convertible bonds are putable

Put options can be classified as hard puts and soft puts

An investor must look carefully at the conversion privilege because not all bonds allow a straightforward conversion privilege

Special Conversion Provisions

mandatory convertible is a convertible security that converts automatically at maturity into shares of the issuers common stock

This automatic conversion differs from convertible bonds where conversion is optional

An investor who purchases a convertible bond rather than the underlying stock typically pays a premium over the current market price of the stock

This premium per share is equal to the difference between the market conversion price and the current market price of the common stock

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

This standard type of call option in a convertible bond is called an unprotected 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

This type of call is known as a protected call

There are issues where the issuer may have the choice of paying the bondholder the cash value of the underlying shares

cash settle

the holder only has the right to convert when the price of the underlying stock exceeds a specified threshold price for a specified number of trading days

contingent convertible provision

The number of shares of common stock that the bond holder will receive from exercising the call option of a convertible bond or an exchangeable bond is

conversion ratio

The conversion value of a convertible bond is the value of the bond if it is converted immediately

conversion value = market price of a common stock x conversion ratio

convertible security must be redeemed by the issuer only for cash

hard put

The market conversion premium per share is usually expressed as a percentage of the current market price

market conversion premium ratio = conversion premium per share / market price of common stock

The price that an investor effectively pays for the common stock if the convertible bond is purchased and then converted into the common stock is called the

market conversion price

Two types of convertible bonds issued prior to 2008 that depart from the traditional conversion privilege are the

net share settlement convertible and the contingent conversion convertible

upon exercise of the conversion option to convert, the issuer pays the par value in cash to retire the bonds but the bond will be trading above its par value. Issuer motivation for the issuance of convertible bonds with this provision (also called cash-par settlement provision) was that from a financial accounting perspective, convertible bonds with net share settlement provisions were treated favorable in the calculation of the issuers earnings per share

net share settlement provisions

Conversion Ratio Formula

par value of convertible bond / conversion ratio

Upon conversion, the bondholder typically receives from the issuer the underlying shares

physical settle

Investors usually use the straight value of the bond as a measure of the downside risk of a convertible bond because the price of the convertible bond cannot fall below this value This the straight value acts as the current floor for the price of the convertible bond the downside risk is measured as a percentage of the straight value and computed as follows

premium over straight value = (market price of the convertible bond / straight value ) - 1 -The higher the premium over straight value all other factors constant the less attractive the convertible bond

The premium payback period (which is also known as the break-even time) is computed as follows

premium payback period = market conversion premium per share / favorable income differential per share

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

soft put

An original issue discount (OID) convertible bond is issued at a discount from par but has some coupon interest:

the coupon interest rate is below market rate