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Convertible Bonds � The ProductPOPS Follow-up Presentation
17 November 2003
Martin Haycock (+44-20-7568 2282)
Convertible basicsSECTION 1
3080381l.ppt 2
Convertible versus straight bond
Straight bond
Pay 100 ... ... get 5% coupon each year ... ... get 100 back
Convertible bond
Pay 100 ... ... get 3% coupon ... CHOICE:... get 100 back or take 10 shares
3080381l.ppt 3
Terminology explained
Premium25%
Amount paid above today�s
share price
Conversion Today�s Premiumprice share price
�10 �8 25%
= +
Conversion ratio10 shares
Number of shares into which each bond converts
Nominal amount Conversion Conversionper bond ratio price
�100 10 shares �10
÷ =
Parity80%
Value of shares underlying bond
Conversion Today�s Parity ratio share price
10 �8 80%
x =
3080381l.ppt 4
Convertible becomes equity if share rises
Bo
nd
pri
ce /
par
ity
Launch Year 1 Year 2 Year 3 Year 4 Year 550
80
100
140
Parity
Bond price
Premium
Bond issued at 100 on 25% premium
3080381l.ppt 5
Convertible becomes a bond if share falls
Bo
nd
pri
ce /
par
ity
Launch Year 1 Year 2 Year 3 Year 4 Year 550
80
100
140
Conversion value
Bond price
Premium
Bond trends to 100 assuming issuer not going bust
3100356L.ppt 6
Convertible payoff
CB value
Stock price
Equity value
Bond floor
Bond Hybrid EquityDistressed
3080381l.ppt 7
It works in reality too...
0
50
100
150
200
250
300
Nov-98 Jan-00 Mar-01 May-02
(%)
Parity FT 2% 2004
3080381l.ppt 8
0
20
40
60
80
100
(%)
Convertibles�two ways to think of them
Bond �floor� moves with credit spread and interest rates, parity moves with the stock price
Bond + Call Stock + Put
Option value
Bond value
Conversionpremium
Conversion value (parity)
3080381l.ppt 9
Convertible termsheet�checklist
Maturity Status / ranking Denomination
Issue price Coupon Redemption price
Conversion ratio Conversion priceConversion premium
Issuer call Investor put Exchange property
Structures and valuationSECTION 2
3080381l.ppt 11
The spectrum of products
Equity
Convertibles can be debt-like or equity-like
Mandatories
Reset
Conventional
Premium redemption
Debt
3080381l.ppt 12
♦ Price to buy convertible remains at 100
♦ Conversion ratio stays at 10 shares
♦ Zero coupon
♦ But backload missing interest payments to maturity
Premium redemption convertibles
Pay 100 ... ... no coupon ...Pay 100 ... ... get 120 or 10 shares... no coupon ...(should be 3%)
3080381l.ppt 13
As well as convertibles, look out for �
Exchangeables
♦ Issued by Company A (credit risk)
♦ Converts into shares of Company B (equity risk)
♦ E.g. News Corp. into BSkyB
Mandatories
♦ Guaranteed conversion into stock
♦ Very equity-like as no downside protection
♦ Pay high coupon, e.g. DT 6.50%
♦ Often exchangeable, e.g. Suez / Fortis,FT / STM
3080381l.ppt 14
Modelling a CB
♦ Maturity
♦ Issue price
♦ Coupon
♦ Redemption price
♦ Discount rate� interest rates
� credit spread
♦ Assumed volatility
♦ Dividend forecasts
♦ Stock price
♦ Conversion premium / price
♦ Call features
Inputs for bond value Inputs for option value
How to value prospectus risk / screws?
3080381l.ppt 15
CB valuation�outputs
♦ Premium
� % difference between CB price and parity
♦ Bond value
� Discounted bond cash flows ie ignores equity option
♦ Yield-to-maturity
� Rate of return of bond cashflows
♦ Theoretical value
� What CB is �worth� if inputs and model hold true
♦ Delta
� Indicates equity short hedge ratio
♦ Implied volatility
� Measure of �cost� of equity option
�Simpler� outputs Model outputs
�Cheap� and �Rich�are a matter of opinion � thus making a market
3080381l.ppt 16
Implied volatility
♦ Most inputs for pricing are straightforward� e.g. coupon, premium
♦ Some require some estimation� dividends
� credit spread
♦ But the most disputed input is volatility� discount to historic volatility
� volatility levels of comparable issues
♦ Once volatility is input, model calculates theoretical value (TV) of CB
♦ Because inputs are so subjective market convention is to use implied volatility
3080381l.ppt 17
Implied volatility
♦ With all other variables fixed, what input volatility gives theoretical value equal to issue price?
♦ With input vol of 25, TV = 102.6
♦ Assume Tau = 0.65
♦ Implied volatility = 25 �
Implied volatility
102.6 � 100.00.65
= 21.0
For outstanding issues, implied volatility relates to current trading price
Worked example
3080381l.ppt 18
Bond floor�worked examples
♦ Discount rate 6%, CB coupon 4%, 5-year maturity
♦ What is bond value?
4(1.06)
+ 4(1.06)2
+ 4(1.06)3
+ 4(1.06)4
+ 104(1.06)5
= 91.57
Worked example 1
♦ Discount rate 7%, 3-year maturity
♦ What is coupon needed to get bond value of 90?
c(1.07)
+ c(1.07)2
+ 100+c(1.07)3
= 90
Worked example 2
c = 3.19% (or approximately 3.25%)
3080381l.ppt 19
Issuer call feature
♦ 5 year convertible with call after three years
♦ Issuer can redeem bonds early in 30 days� time (at 100%)
♦ If parity above 100% investors would rather convert
♦ Soft call:� bonds only callable if parity above e.g. 130%
� helps issuers extract better value from investors
� 30 day share price risk means some cushion needed anyway
Powerful tool for issuers to force conversion
3080381l.ppt 20
Rules of thumb�call feature
♦ 5-year maturity with NC3 (130%) most common today
♦ Why have a trigger?� improves other terms versus unconditional call
� pragmatic �cushion� required to exercise unconditional call over30 days, so might as well have trigger
♦ Call timing� investors are wary of calls less than three years
� investors could lose a lot of option value if exercised
� but they may be key to meeting issuer�s needs
3080381l.ppt 21
Rules of thumb�premium redemption
♦ Yield to maturity 50bp more than conventional
♦ Premium unchanged
♦ Why?� premium redemption less likely to convert
� investor needs compensation for lower option value
� investor needs compensation for lost coupon income
Zero coupon
♦ May need even more yield
♦ May need lower premium
♦ Dividend income loss effects more pronounced
3080381l.ppt 22
Rules of thumb�puts
♦ One-time option
♦ Allows investor to get money back before maturity
♦ Effectively shortens maturity
♦ Investors value to put date not maturity
♦ Smoke and mirrors tactic by banks
� give issuer and investor maturities they want
� long dated zero coupon deals issued at a discount
� e.g. Roche �US$3 billion� deal only raised US$1.2 billion
3080381l.ppt 23
A CB is not a bond plus warrants
♦ Can a CB be valued as a bond plus a call option?
♦ Whilst similar, the two are not the same� investor bases different� �usability� i.e. floating strike option� warrants not callable
♦ CB pricing software more complex than Black-Scholes
3080381l.ppt 24
The Greeks
♦ Change in theoretical value for +1% change in stock
♦ Dictates stock to sell short to neutralise equity risk
♦ Typically 50�70% at issue
Delta
♦ Change in Delta for +1% change in stock
♦ Positive number�Delta increases as stock risesGamma
♦ Change in theoretical value for +1% change in volatility
♦ Typically around 0.70
♦ e.g. 20% vol = 101.4% TV21% vol = 102.1% TV
Tau / Vega
3080381l.ppt 25
UBS Limited1 Finsbury AvenueLondon, EC2M 2PP
Tel: +44-20-7567 8000
www.ubs.com
UBS Investment Bank is a business group of UBS AG UBS Limited is a subsidiary of UBS AG.
Contact information
Head of Convertibles MarketingTel: +44-20-7568 2282email: [email protected]
Web pages: www.ubs.com
Bloomberg: UCBR,UCBI,UCBP
Reuters: CBMENU
Martin Haycock
3080381l.ppt 26
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