CONVERTIBLE SECURITIES

CHAPTER FOURTEEN

Practical Investment Management

Robert A. Strong

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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

conversionvalue

conversionratio

currentstock price= X

conversion price =par value

conversion ratio

premium overconversion value = -

marketprice

conversionvalue

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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 Bondst

ock

pri

ce

time

conversion price

commonstock

equivalent

rising stock price

Acts like a Stock

bustedconvertible

declining or slow rising stock price

Acts like a Bond

newconvertible

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 conversionfeature 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 sometimescalled the break-even time.

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Calculating Premium Payback Period

ratio conversion

valuemarket price conversionmarket

ratio conversion

share per dividendsratio conversion -interest bondprice stock - price conversionmarket

Premium payback period =

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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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The exercise price is the price at which an investor holding warrants may buy the underlying shares.

When the stock price rises above theexercise 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.

Pricing of Warrants

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Pricing of Warrantsw

arra

nt

pri

ce

stock price

actual marketvalue

45ºmax

imum

val

ue (=

sto

ck p

rice)

exercise price

45º

min

imum

val

ue

(= s

tock

pric

e m

inus

exer

cise

pric

e)

Assumption: One warrant is required to buy one share of stock.

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Speculators buy warrants because of theleverage they provide.

Warrants and Leverage

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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