Convertble Bonds SA 4 8 14

8/12/2019 Convertble Bonds SA 4 8 14

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Pros and cons

There are pros and cons to the use of convertiblebondsas a means of financing by corporations.

One of several advantages ofthis delayed method ofequity financingis a delayed dilutionof common stock

and earnings per share (EPS). Another isthat the company is able to offer the bond

at a lower couponrate - less than it would have to payon a straight bond.

The rule usually is that the more valuable theconversion feature, the lower the yield that must beoffered to sell the issue; the conversion feature is asweetener.
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Advantages of Debt Financing

Thus, when a company is considering alternativemeans of financing, if the existing management groupis concerned about losing voting control of thebusiness, then selling convertible bonds will provide an

advantage, although perhaps only temporarily, overfinancing with common stock.

In addition, bond interest is a deductible expense forthe issuing company, so for a company in the 30% taxbracket, the federal government in effect pays 30% of

the interest charges on debt. Thus, bonds haveadvantages over common and preferred stockto acorporation planning to raise new capital.
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What Bond Investors Should Look For?

Companies with poor credit ratings often issueconvertibles in order to lower the yieldnecessaryto sell their debt securities.

The investor should be aware that somefinancially weak companies will issue convertibles

just to reduce their costs of financing, with nointention of the issue ever being converted.

As a general rule, the stronger the company, thelower the preferred yield relative to its bondyield.
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There are also corporations with weak creditratingsthat also have great potential for growth.

Such companies will be able to sell convertibledebt issues at a near-normal cost, not because ofthe quality of the bond but because of theattractiveness of the conversion feature for this"growth" stock.

When money is tight and stock prices are

growing, even very credit-worthy companies willissue convertible securities in an effort to reducetheir cost of obtaining scarce capital.
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Most issuers hope that if the price of their stocks rise,the bonds will be converted to common stock at a pricethat is higher than the current common stock price.

By this logic, the convertible bond allows the issuer tosell common stock indirectly at a price higher than thecurrent price.

From the buyer's perspective, the convertible bond isattractive because it offers the opportunity to obtain

the potentially large return associated with stocks, butwith the safety of a bond.


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The Disadvantages of Convertible

Bonds There are some disadvantages for convertible bond

issuers, too.

One is that financing with convertible securities runs therisk of diluting not only the EPS of the company's common

stock, but also the control of the company. If a large part of the issue is purchased by one buyer,

typically an investment bankeror insurance company,conversion may shift the voting control of the companyaway from its original owners and toward the converters.

This potential is not a significant problem for largecompanies with millions of stockholders, but it is a very realconsideration for smaller companies, or those that have

just gone public.
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Other disadvantages

Many of the other disadvantages are similar to thedisadvantages of using straight debt in general.

To the corporation, convertible bonds entailsignificantly more risk of bankruptcythan preferred orcommon stocks.

Furthermore, the shorter the maturity, the greater therisk.

Finally, note that the use of fixed-income securitiesmagnifies losses to the common stockholderswhenever sales and earnings decline; this is theunfavorable aspect of financial leverage.
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Indenture provisions

The indentureprovisions (restrictive covenants)on a convertible bond are generally much morestringent than they are either in a short-term

credit agreement or for common or preferredstock.

Hence, the company may be subject to muchmore disturbing and crippling restrictions under a

long-term debt arrangement than would be thecase if it had borrowed on a short-term basis, orif it had issued common or preferred stock.
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Finally, heavy use of debt will adversely affect acompany's ability to finance operations in timesof economic stress.

As a company's fortunes deteriorate, it willexperience great difficulties in raising capital.Furthermore, in such times investors areincreasingly concerned with the security of their

investments, and they may refuse to advancefunds to the company except on the basis of well-secured loans.


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A company that finances with convertible debtduring good times to the point where itsdebt/assets ratio is at the upper limits for its

industry simply may not be able to getfinancing at all during times of stress.

Thus, corporate treasurers like to maintainsome "reserve borrowing capacity". Thisrestrains their use of debt financing duringnormal times.


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Why Companies Issue Convertible

Debt?

The decision to issue new equity, convertible

and fixed-income securities to raise capital

funds is governed by a number of factors.

One is the availability of internally generated

funds relative to total financing needs. Such

availability, in turn, is a function of a

company's profitability and dividend policy.
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Debt?

Another key factor is the current market price ofthe company's stock, which determines the costof equity financing.

Further, the cost of alternative external sourcesof funds (i.e., interest rates) is of criticalimportance. The cost of borrowed funds, relativeto equity funds, is significantly lowered by thedeductibility of interest payments (but not of

dividends) for federal income tax purposes.


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Debt?

In addition, different investors have different

risk-return tradeoff preferences. In order to

appeal to the broadest possible market,

corporations must offer securities that interestas many different investors as possible.

Also, different types of securities are most

appropriate at different points in time.


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Conclusion

Used wisely, a policy of selling differentiatedsecurities (including convertible bonds) to takeadvantage of market conditions can lower a

company's overall cost of capital below what itwould be if it issued only one class of debt andcommon stock.

However, there are pros and cons to the use of

convertible bonds for financing; investors shouldconsider what the issue means from a corporatestandpoint before buying in.


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Understanding Warrants

Investors who purchase warrants inherit the right topurchase the underlying stock or bond at a predeterminedprice and time. Investors are not obligated to purchase theunderlying asset.

Unlike convertible securities, investors who trade warrantsmust pay additional money to obtain the companyscommon stock. The time horizon of warrants varies, butmany warrants are held for several years.

The value of a warrant is made up of two componentstime and intrinsic value. The longer time left untilexpiration, the greater the value of the warrant. Intrinsicvalue relates to when the market share of the underlyingasset is greater than the exercise price.


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Pros and Cons of Warrants

A primary advantage of investing in warrants is thatinvestors can potentially earn large returns with only asmall amount of money used to purchase the warrantcontract.

Warrants offer investors diversity through a variety ofunderlying assets included in warrant contracts. Warrantsare liquid assets, which is beneficial if the investor choosesto sell the contract instead of exercising the warrant.

A disadvantage of investing in warrants is that you do notenjoy the benefits of stock ownership until you purchasethe underlying asset. A warrant is a risky investment, andbecomes worthless if the market value of the asset declineslower than the exercise price.


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Understanding Convertible Securities

A company without access to bank financing and othertraditional financing options may issue convertibles inan effort to raise quick capital.

Convertible securities are longer-term investments

than warrants, and are usually issued as bonds orpreferred stocks that investors can convert to apredetermined number of shares of the companyscommon stock.

The number of shares given to investors is determined

by the conversion ratio. For example, a conversion of50 to 1 means that investors can convert one bondwith a $1,000 face value to 50 shares of common stock


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Pros and Cons of Convertibles

The combination of bond and stock attributes makes convertiblesecurities beneficial for investors.

An advantage of investing in convertible securities is if thecompanys stock price is undervalued, you can earn a significantrate of return. Investors benefit from convertible bonds because the

bond pays a fixed rate of interest until it is converted. This isespecially beneficial if the company does not pay a dividend.

A disadvantage of investing in convertible securities for someinvestors is the need to understand the bond and equity markets.Convertible bonds are tied to the issuing companys credit ratingand typically pay less interest than regular corporate bonds. A

disadvantage of investing in convertible bonds is that companieswith poor credit ratings have a greater risk of defaulting.


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Conversion Premium

The amount by which the price of a convertible securityexceeds the current market value of the common stock intowhich it may be converted.

A conversion premium is expressed as a dollar amount andrepresents the difference between the price of theconvertibleand the greater of the conversion or straight-bond value.

Convertibles are securities, such as bonds and preferredshares, that can be exchanged for a specified number ofanother form (typically common stock) at an agreed-uponprice.

Convertibles can be converted at the will of the investor orthe issuing company can force the conversion.


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Conversion Premium

The equity value of a convertible bond was determined to be its conversion value.

Conversion premium can be calculated easily by simply taking the differencebetween the current market price of the convertible and the conversion value andexpressing it as a percentage.

Since the convertible bond is more secure than common stock and generally payshigher interest than the stock dividend, the convertible bond buyer is willing to

pay a premium over conversion value. Market forces determine the amount of premium that a particular convertible may

command in the marketplace.

However, it should make sense that, as a convertible bond price increases aboveits investment value, its fixed income attributes give way to equity characteristics,decreasing the conversion premium. On the other hand, if the stock price declines,the convertible bond price approaches its fixed income value and the conversion

premium increases. Convertible bonds that are trading near their fixed income values with substantial

conversion premiums are called "busted converts." Their equity component is oflittle value, and they trade mainly on their fixed income characteristics.


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Figure(next slide) depicts a typical convertibleprice curve, with the shaded area denotingconversion premium.

Notice that as the stock increases in value,conversion premium gradually decreases until itbecomes zero.

At that point, the convertible market price andconversion value are equal.

As the common stock declines in value, theconvertible gains conversion premium because itis approaching its investment value.


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Conversion premium


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Convertible Bonds: An Example

XYZ Company

Convertible Bond Coupon 5% Maturity 10 years Straight bond yield to maturity 8% Conversion price $50/share Current stock price $42/share Conversion ratio 20 shares per bond


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Convertible Bond


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A Convertible's Investment Value


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Investment Value Calculation

=50 Annuity factor(8%,10years)+1000

PVIF(8%,10 years) =50(6.710)+1000(0.463)

= 335.50+463.00=798.50


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Investment Premium

The convertible bond's investment premium is thedifference between the convertible's market price andits investment value, expressed as a percentage.

An important measure of the basic value of the

convertible is its premium over investment value.

This value is important because it indicates the level ofdownside risk and can be monitored as market priceschange. For example, in the case of a bond with a par

value of $1,000 and an investment value of $798.70,the investment premium is ([1,000 - 798.70]/ 798.70),or 25.2 percent.


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Similarly, when the investment premium is small,a small decrease in the value of the underlyingstock would result in the market price reachingthe investment value.

At that time, the investment value floor serves assignificant downside protection.

Furthermore, when the investment premium issmall, the convertible is more interest rate

sensitive rather than equity sensitive and willtypically be vulnerable to changes in marketinterest rates.


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Basic convertible bonds calculations

stock price $30.00 per share

stock dividend $0.50 per share

convertible market price $1,000

coupon rate 7.00%

maturity 20 years

conversion price $36.37

Stock dividend yield = annual dividend rate/current stock price= $0.50 / $30.00 = 1.67%


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Conversion ratio

= number of shares for which one bond may be

exchanged

= par / conversion price = $1,000 / $36.37 = 27.50 shares

Conversion value

= equity value or stock value of the convertible

= stock price x conversion ratio = $30.00 x 27.50 = $825.00


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Conversion Premium Calculation

Conversion premium = (convertible price

conversion value) / conversion value

= ($1,000$825.00) / $825.00 = 21.21%


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Conversion premium

In a bullish environment, the enthusiasm of the marketboosts conversion premium levels.

National Semiconductor Corporation (Sept 1995)

coupon rate 6.5 percent and conversion premium of

45 percent. 3Com Corporation (Nov., 1994)coupon rate

10.25 percent and conversion premium of 70

percent.

Bondholders are compensated with a highcoupon rate while they wait for the stock price to

rise.


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Factors that affect the bond

component

Interest rates

Credit rating/spreads

Coupon

Duration


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Factors that affect the warrant

component

Stock performance

Embedded strike price

Common dividend yield and dividend

growth rate

Stock volatility

Life of warrant / call protection


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Floor value

The floor value of a convertible bond is the greater of 1. Conversion value

2. Bond investment valuevalue as a corporate bond

without the conversion option (based on the convertible

bonds cash flow if not converted). To estimate the bond investment value, one has to

determine the required yield on a non-convertible bond

with the same quality rating and similar investment

characteristics. If the convertible bond does not sell for the greater of

these two values, arbitrage profits could be realized.


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Bond investment value

Present value of the interest and principal payments discounted atthe straight (non-convertible) bond interest rate

bond interest value =

where P = par value, r = discount rate, C = coupon rate,

n = number of periods to maturity.

take r = 10% present present

value value

Years payment factor

1 - 20 $80 8.514 $681.12

20 $1,000 0.149 $149.00

$830.12


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Estimation of the discount rate

Use the yield-to-maturity of a similarnonconvertible bond as a proxy.

Ratings are not very responsive to changing

financial fundamentals. The apparent deterioration of the

creditworthiness of an issue will not be

reflected in the convertible price because thecommon stock may be rising due to highershare price volatility.

Documents

Convertble Bonds SA 4 8 14