Convertible Bonds Course

8/6/2019 Convertible Bonds Course

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Convertible Bonds

Structuring a convertible issue


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Definitions Convertibles bonds are used by firms to

raise funds. Convertible securities are bonds (preferred

stocks) that are exchangeable into

common stock at the option of the holderand under specified terms and conditions.

Thus the convertible holder owns anoption to convert the bond to commonshares.


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Definitions The exercise of the conversion option

does not bring any additional cash to thefirm. The debt on the balance sheet issimply replaced by common stock. The

reduction of the debt ratio brings inadditional debt capacity.

The conversion of bonds therefore creates

additional shares which leads to thedilution for the existing shareholders.


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Example of a convertible National Electric Company needs to raise cash

for funding its capital investments to meet theincreased demand. It decides to issueconvertible bonds. The issue is structured asfollows.

Issued at par value of 1000, coupon 30 paidyearly, maturity 10 years. The bond isconvertible into 50 shares of the company, atany time up to its maturity. The firm can call

back the bond any time after three years fromthe date of issue. The redemption value is fixedat par.


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NEC Convertible NEC issues 90,000 convertibles. The current trading price of the NEC shares is 16.

The conversion price is fixed at 2O, which is 25 percenthigher than the current trading price.

Currently the number of outstanding shares is 11 million.

If all the convertible holders exercise the conversionoption 4.5 million new shares will be created. Theshareholders equity will increase by 90 million.

Conversion price=Par value of bond/shares received.

Generally, the conversion ratio is fixed for life, althoughsometimes a stepped up conversion price can be used.


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Parameters of a convertible Coupon/interest rate

Maturity.

Conversion ratio

Period when conversion option can be

exercised.

Call provision

Par value/ issue price. Conditions under which the convertible can be

called back (period, redemption value).


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Apparent advantages of convertibles

As a sweetener when selling debt. The firm can

sell debt at a lower cost. Less restrictivecovenants. Access debt market, which might bedifficult otherwise.

Sell common shares at a higher price than thosecurrently prevailing. Usually, the conversionprice is fixed around 15-25 percent higher.

Lower dilution ratio.

Signaling that the current trading price does notreflect the true price of the share.


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Disadvantages of convertibles Although, the convertibles enable firms to

sell at a higher price than the prevailingprice, but if the stock price goes up rapidly,the firm would have been better off to waitand issue equity.

If the price of stock falls, the firm is stuck

with the debt. The floatation costs are usually high.


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Accounting principles. Cash raised is assimilated in the medium

and long term loans. When conversion option is exercised, the

proceeds are transferred to theshareholders equity.

The EPS are calculated both on the basis

of no conversion and also if conversionoption is exercised.


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Rationale of Convertible bonds Why firms issue convertible bonds?

Is the reasoning that convertiblescorrespond to win/ win situation? If

exercised then the firm reinforces itsequity at a higher price, if not firm is ableto borrow at a cheaper rate.

If this is the case why firms rarely useconvertibles?


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Rationale Analytical studies show that the difference

in interest rates (coupon) between twofirms with different ratings is lower in thecase of convertible issues than in the case

of the same firms issuing straight bonds allother things being equal.

This indicates that convertibles are far less

sensitive to risk perception of the issuingcompany than straight bonds.


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Valuation of convertibles Convertible is a package of two securities: a straight

bond and a certain number of call options. This is the simplest form of convertibles.

Value of a convertible = value of the straight bond +Value of the conversion option.

In general, a convertible is composed of a straight bondand a certain number of embedded options.

For example, the issuer might include an option to

redeem the convertible at predetermined conditions. Thisis often used to force conversion.


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Convertibles and the secondary market

Convertibles are traded in the secondary

market (considerable demand with theincrease in the number of hedge funds).

One can talk about three values: the pure

bond value, trading price of theconvertible, conversion value of theconvertible.

Conversion value= conversion ratio Xtrading price of the underlying share.


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Trading price Trading price>Max (pure bond value,

conversion value). Convertibles are therefore interesting for a

certain category of investors as the

downside risk is limited. Convertibles can be classified into three

categories.

Trading price-Max (pure bond value-conversion value) =conversion premium.


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Convertibles and the secondary market

Quasi interest rate securities, when stock price

is very much lower than the conversion price. Mixed equity type security, sensitive to both

changes in the interest rate and changes in the

underlying stock price. Quasi equity type security, very little sensitive to

interest rate changes, when the stock price is

very much higher than the conversion price.


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Relationship between the convertible price and the share

price

Stock price

Convertible

price

Conversionvalue

Pure bond value


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Conversion Voluntary conversion by the holders: if

share price is higher than the conversionprice and if the revenues from conversionare higher than the revenues obtained byholding the convertibles.

Forced conversion

Purchase in the market


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Problems in valuing convertibles

As convertible is a package of a straight bond and a set

of call options, the convertibles can be valued by valuingthe two components separately. The convertible, mayinclude other embedded options. This makes valuationmore complex.

The straight bond should be valued by discounting thecoupons and the repayment value.

The call options can be valued using option pricing

models.


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Problems It is difficult to estimate the parameters;

The discount rate for the pure bond can beobtained from the secondary market andthe yield curves of bonds.

The maturity is not known.

How to deal with redemption premium,sinking fund provisions, green shoe option.

Estimations of volatility, historical orimplied.


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Settling the terms of a convertible issue

A firm raising funds through convertibles

will seek to set terms that will cause itsbonds to just clear the market. Investmentbanks act as advisers and are part of the

selling syndicate. If the convertibles are under-priced, the

current shareholders bear the cost, on the

contrary if the convertibles are overpriced,the firm will not be able to sell the issue.


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Key variables Variables outside the firms control:

The current trading price of the stock

The expected growth rate of the stock price.

When would the investors exercise their

options.

Expected return on the non convertible debt.

The volatility of the returns on the stock.


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Key variables Controllable variables:

Par value, issue price, maturity value.

Coupon (interest rate).

Conversion ratio, conversion price.

Redemption premium.

Green shoe option, sinking fund provision.

Call provision.


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Structuring an Issue: An example

Let us take the example of the NEC:

Issue price 1000

Convertible coupon 30

Conversion Ratio 50

Conversion price 20

No sinking fund provision.

Call provision. No redemption provision.


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Market determined parameters

Current trading price of the stocks of NEC = 16.

The volatility of the returns on the NEC stocks =0.25

The dividend yield = 2 percent.

The yield on NEC non convertible debt is 6percent per annum.

Given the current growth rate of stock prices thefirm expects that the conversion will take place

in 4 years.


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Pure bond value

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Option value

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Call option price

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Convertible Value

Estimated theoretical value of the

convertible, assuming that the conversiontakes place in 4 years:

Pure bond value+ conversion value

896.04 + 50 x 1.984x0.710=966.47

Estimated value is therefore less than the

issue price. It would be difficult to clear the issue.


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Structuring the issue In the given example, the firm needs to

review the parameters to ensure that theissue is attractive to the investors.

Most new issues are sold at a discount.

The discount depends upon the prevailingmarket sentiments and the complexity ofthe issues.

Convertibles are usually bought by theinstitutional investors.


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Pricing a convertible issue Most convertibles would have a call provision

and may be an option for the holders to sell theconvertible to the issuing firm after a certain

period of time. These convertibles are more

difficult to price. These convertibles are a package of several

options, a series of call options owned by the

holder, put options owned by the issuingcompany and put options owned by the holder.


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Cost of funds using convertible issues

Another issue which is interesting for firms

is to know what is cost of raising debt byissuing convertibles. We can suppose thatconvertibles would cost more than pure

debt and should cost less than cost ofpure equity. The CAPM can be used toestimate the cost of convertibles or whatkind of return the convertible buyersshould expect.


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Cost of convertible debt

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Cost of convertibles

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Convertible Bonds Course

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