Convertible Bond Lecture

8/3/2019 Convertible Bond Lecture

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ANALYSIS OF

CONVERTIBLE BONDS

ANALYSIS OFANALYSIS OF

CONVERTIBLE BONDSCONVERTIBLE BONDS


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A convertible bond

a corporate bond with a call option tobuy the common stock of the issuer.The conversion provision in a

corporate bond issue grants thebondholder the right to convert thebond into a predetermined number ofshares of common stock of theissuer.


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A corporate bond without theconversion option - straight value


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Suppose you have a 10% bond that payssemiannual coupons and will mature in 15 years.The face value is $1000 and the yield to

maturity on similar bonds is 9%. The bond isalso convertible with a conversion price of$100. The stock is currently selling for $110.

Straight bond value = 1081.44


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Conversion ratio

The number of shares of commonstock that the bondholder willreceive from exercising the call

option of a convertible bond or anexchangeable bond


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Suppose you have a 10% bond that payssemiannual coupons and will mature in 15 years.The face value is $1000 and the yield to

maturity on similar bonds is 9%. The bond isalso convertible with a conversion price of$100. The stock is currently selling for $110.

Conversion ratio = 1000/100 = 10


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Convertibles

The conversion price is the effective pricepaid for the stock


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Upon conversion, the bondholder

typically receives from the issuer theunderlying shares. This is referred toas a physical settle.

The issuer may have the choice ofpaying the bondholder the cash valueof the underlying shares. This is

referred to as a cash settle.


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Most convertible bonds are callable at theoption of the issuer.

Some convertible bonds are putable. A hard put is one in which the convertible

security must be redeemed by the issuer only

for cash. A soft put is one in which the issuer has theoption to redeem the convertible security forcash, common stock, subordinated notes, or a

combination of the three.


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MINIMUM VALUE OF A

CONVERTIBLE BOND

conversion value the value of the bond if it is convertedimmediately.

conversion value = (market price ofcommon stock)(conversion ratio).


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Suppose you have a 10% bond that payssemiannual coupons and will mature in 15 years.

The face value is $1000 and the yield tomaturity on similar bonds is 9%. The bond isalso convertible with a conversion price of

$100. The stock is currently selling for $110. Conversion ratio = 1000/100 = 10

Conversion value = 10*110 = 1100


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Convertible bonds will be worth at least asmuch as the straight bond value or theconversion value, whichever is greater

The minimum price of a convertible bond isthe greater of its conversion value or itsvalue as a corporate bond without theconversion option - straight value


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market conversion price= (market price of convertible bond) /(conversion ratio).

market conversion premium per share= market conversion price currentmarket price.


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Suppose you have a 10% bond that payssemiannual coupons and will mature in 15 years.The face value is $1000 and the yield to maturity

on similar bonds is 9%. The bond is alsoconvertible with a conversion price of $100. Thestock is currently selling for $110. The bondmarket price is $1200.

Market conversion price = 1200/10 =120

Market conversion premium per share =

120 -110 = 10


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

The market conversion premium pershare can be seen as the price of acall option.


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CURRENT INCOME OF

CONVERTIBLE BOND VERSUSSTOCK As an offset to the market conversion premium

per share, investing in the convertible bondrather than buying the stock directly generallymeans that the investor realizes higher currentincome from the coupon interest paid on theconvertible bond than would be received asdividends paid on the number of shares equal tothe conversion ratio. Analysts evaluating aconvertible bond typically compute the time ittakes to recover the premium per share by

computing the premium payback period (which isalso known as the break-even time).


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Premium payback period

= Market conversion premium per share /Favorable income differential per share

Favorable income differential per share

= (coupon interest from bond (conversion ratio xdividend per share)) / conversion ratio.

Notice that the premium payback period does not

take into account the time value of money.


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Suppose you have a 10% bond that pays

semiannual coupons and will mature in 15years. The face value is $1000 and the yieldto maturity on similar bonds is 9%. The bondis also convertible with a conversion price of

$100. The stock is currently selling for $110and pays dividend of $5. The bond marketprice is $1200.

Market conversion price = 1200/10 =120 Market conversion premium per share = 120 -110 = 10 Favorable income differential per share

= (100-(5*10))/10 = 5

Premium payback period= 10/5 = 2 years


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DOWNSIDE RISK WITH ACONVERTIBLE BOND

The straight value of the bond as a measure of

the downside risk of a convertible bond, becausethe price of the convertible bond cannot fallbelow this value.

Currentfloor for the price of the convertiblebond.


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DOWNSIDE RISK WITH ACONVERTIBLE BOND

premium over straight value

= (market price of the convertible bond / straightvalue) 1.

The higher the premium over straight value, allother factors constant, the less attractive theconvertible bond.


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INVESTMENT CHARACTERISTICS OFA CONVERTIBLE BOND

If the price of the stock is low, so thatthe straight value is considerably higherthan the conversion value, the bond willtrade much like a straight bond.

Then, the convertible bond in suchinstances is referred to as a bondequivalent or a busted convertible


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INVESTMENT CHARACTERISTICS OFA CONVERTIBLE BOND

When the price of the stock is such thatthe conversion value is considerably higherthan the straight value, the convertiblebond will trade as if it were an equity

instrument. (an equity equivalent ) Otherwise, hybrid security


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PROS AND CONS OF INVESTING INA CONVERTIBLE BOND

Buyer. Issuer.


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BuyerLower return More expensive. Low coupon.Unless the interest payments for the length

of ownership cover the higher price paid per share and any dividends that are forgone for the

length of time.


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Buyer Call risk

callable by issuers. current market price of issuers stock

undervalued enough so that selling stock

directly would dilute the equity of currentstockholders.

Takeover risk the stock of the acquired company may no

longer trade after a takeover


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Buyer

Advantage of buying the bond its value will likely fall less than that ofstock if a firm runs into financialdistress difficulties.


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OPTIONS APPROACH (i) buying a noncallable/nonputable straight bond,

and (ii) buying a call option on the stock, where the

number of shares that can be purchased with the

call option is equal to the conversion ratio. Convertible bond value

= straight value

+ price of the call option on the stock


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A convertible bond: the issuers right to call thebond. If called, the investor can lose any premiumover the conversion value that is reflected in themarket price. Therefore, the analysis ofconvertible bonds must take into account thevalue of the issuers right to call the bond. Thisdepends, in turn, future interest rate volatility,and economic factors that determine whether itis optimal for the issuer to call the bond.


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binomial option pricing model can beused simultaneously to value thebondholders call option on the stock

and the issuers right to call thebonds.


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Convertible Bond Lecture

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