HybridSecurities.doc

7/28/2019 HybridSecurities.doc

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HYBRID SECURITIES

Preferred Stock

dividends have been paid. Typically, preferred stock dividends are cumulative so that alldividends Preferred stock is a hybrid instrument; it is like debt but it is also like equity. The

dividends on preferred stock are generally set at a specific dollar amount per share, oftenexpressed as a percentage of par value. There is also dividend preference the companycannot pay any common stock dividends until the preferred stock in arrears on preferred stockmust be paid before common stockholders can be paid anything. It is not uncommon thatdividends in arrears also carry an interest rate that accumulates.

In the event of liquidation, preferred shareholders will be repaid the par value of thepreferred stock.

While the standard type of preferred stock pays a constant dividend and never matures,there is a wide variety of provisions that may be included in a preferred stock issue:

Sometimes the preferred stockholder get to vote. There may be a maturity date and sinking fund provision.

Sometimes there is a call provision.

On rare occasion, there is what is known as participating preferred stock thatparticipates in the profits up to a limit during unusually good years.

Very often the preferred stock is convertible into common shares. Many times theability to vote is linked to the conversion feature and the preferred stockholders canvote as if they had converted into common stock.

You will often see preferred stock used in small companies that need to raise additionalcapital. The investors, typically venture capitalists, will invest money in the form of convertible

preferred stock. Thus, if the company prospers and the common stock becomes worth asignificant amount, the investor can convert to common stock and cash in on the companysgood fortunes. On the other hand, if the company ultimately founders or fails, the investor isfirst in line to get paid dividends or to be repaid from any proceeds that remain after liquidation.

Advantages of Preferred Stock to the Investor

Relatively steady income (relative to common stock).

Preference over common stock in liquidation.

Dividends paid to corporations owning the preferred stock are excluded from income to asmuch as a 70% extent.

Disadvantages of Preferred Stock to the Investor

Returns are limited.

There is no enforceable right to dividends (unlike interest payments that must be paidannually).


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There is high risk due to price fluctuations. Recall from our discussion of valuation ofsecurities that preferred stock is a perpetuity and perpetuities are the mostsensitive tochanges in interest rates.

Advantages of Preferred Stock to the Company

There is no fixed charge that must be paid each year. There is no maturity.

No dilution of control (unless convertible).

The cost is less than the cost of common equity. While the first two advantages are thesame as the advantage of using common stock, the cost is less. Why? Because the risk tothe investor is less than that of common stockholders.

Disadvantages of Preferred Stock to the Company

Cost is higher than debt.

Dividends are not tax-deductible.

From the perspective of a bondholder, preferred stock is like common equity. It providesfor more assets that generate income that is used to pay lenders their interest first and providesmore asset that can be liquidated to pay lenders their principal first if the firm goes bankrupt.

From the perspective of a common stockholder, on the other hand, preferred stock is likedebt. The preferred stock dividends must be paid first (and also act as leverage in terms ofmagnifying the variability of income) and the preferred stockholders are ahead of the commonshareholders in the event of liquidation (just like lenders).

Preferred Stock Valuation

The classic version of preferred stock is a share that pays a fixed dollar amount ofdividend and never matures. It is, therefore, a perpetuity. The formula for the value of a shareof preferred stock is

pr

DividendStockPreferredofValue =

Since the plain vanilla type of preferred stock is a perpetuity, its value is very sensitiveto changes in interest rates.

Options

Typically, when people talk about options on stocks, they are referring to thestandardized options that are traded on exchanges. These standardized options are for 100shares of stock and have maturity dates that go up to nine months in three-month intervals.

Also, the exercise price (or strike price) is always in specified intervals of two and one-half or


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five dollar increments. A call option gives the holder of the option the right to buy 100 shares ofstock at a set price (strike price, or exercise price) during a set period of time (until expiration).

A put option gives the holder (owner) of the option the right to sell 100 shares of stock at a setprice during a set period of time. Options are part of a set of securities referred to asderivatives due to the fact that their value is derivedfrom some underlying asset.

An options value is a function of five factors:

1. Market price of the stock2. Strike price of the option3. Time to maturity of the option4. Volatility of the underlying stock5. Risk-free rate of interest

The following graph illustrates the value of a call option at different market prices of theunderlying stock given a set strike price, maturity date, etc.

Value of IntrinsicOption Value

Market Value

0Stock Price

The intrinsic value (blue line) is the value of the option if it were to be exercised at that point intime.

Intrinsic Value = Max(M-S,0)

Note, however, that the market value is always higher than the intrinsic value due to thespeculative appeal of an option (except on expiration date when the two should converge). Forexample, if the exercise price is higher than the market price, the intrinsic value is zero since itis irrational that one would pay a higher price to buy the stock through an option exercise thanwhat it would cost to purchase on the open market. As long as there is some time before the

expiration of the option, there is a chance that the market price will move above the strike price,thereby making the option in the money and worth exercising.

Warrants and Convertibles

A firm must often add features to make its debt more attractive. In times of high interestrates, it is undesirable to raise money in general because the rate of interest paid on debt will be


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high and stock prices will be low. In order to help offset the high interest rates that prevail, afirm may add a sweetenerto its debt in order to make it more attractive to investors.Warrants

A warrant is an option to buy stock at a set price. In this sense, it is an option. Thedifference is that a warrant typically does not expire for many years. A warrant will often be

issued in conjunction with a bond issue. If you buy a bond, you receive a warrant that entitlesyou to purchase a fixed number of shares at a fixed price during a fixed period of time.Sometimes, the exercise price will increase over time in order to encourage the warrant holdersto exercise the option sooner. The intrinsic value of the warrant is

W = Max{0,N*(M-S)}

WhereN = the number of shares the warrant entitles you to buyM = the market price of the stockS = the subscription price of the warrant to buy the stock

A warrant is generally issued at the same time as a fixed income security (bond or preferredstock) in order to make the security more attractive to investors.

At the time of the issue, the subscription price is generally set anywhere from 15%-20%above the market price. Consequently, it does not make sense to exercise the warrant at thetime of issuance. However, the warrants speculative appeal lies in the fact that the stock pricemay increase substantially in the future, making the warrant valuable.

If an investor had to choose between two identical bonds with identical maturities andpaying and identical rate of interest, but with one bond offering a warrant that, although notworth exercising at the time of issuance, the bond with the warrant would be perceived as morevaluable since the stock may appreciate substantially. Since investors would prefer the bond

with the warrant, what can we do to make investors indifferent between the two bonds? Theeasiest way to make the bond with the warrant less attractive (i.e., equivalent to the straightbond without a warrant) is to lower the coupon rate of interest that it pays.

A warrant is detachable from the bond. That is, a separate market exists for the warrant.If you buy a bond with a warrant attached, you can keep the bond and sell the warrant or keepthe warrant and sell the bond. Also, just like an option, a warrant will sell for more than itsintrinsic value (as in the above equation) since it has speculative appeal. Just as you can buythe price movement of a share of stock using a call option, you can buy the right to N shares ofstock simply by purchasing the warrant.

The risk on the downside of purchasing a warrant is limited to the amount that is paid for

the warrant which is less than if you purchased the stock. On the other hand, the upsidepotential is unlimited. The effect of purchasing a warrant is the leverage that is provided bothgains and losses are magnified.

Convertible Bonds

Just as warrants make a bond more attractive to investors, adding a conversion featuremakes a bond more attractive. A convertible bond gives the bondholder the right to convert the


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bond into a specified number of shares of common stock. The number of shares that aconvertible bond is convertible into is referred to as the conversion ratio. Typically, thenumber of shares that a bond is convertible into is specified through what is known as theconversion price. In this sense, a convertible bond is said to have an embedded option; i.e.,the bond comes with a non-separable option to purchase stock at the strike price ofsurrendering the bond.

Conversion Price =Par Value

Conversion Ratio

Thus, if a $1,000 par value bond is convertible into 20 shares of common stock, the conversionprice will be $50 per share. The reason for expressing the conversion ratio as a conversionprice arises from the fact that most convertible bonds are protected against dilution. If a firmwere to declare a two-for one stock split, for instance, the conversion price would be cut in half(i.e., the number of shares that the bond is convertible into would be doubled).

As in the case of warrants, convertible bonds are generally issued when interest ratesare high (a bad time to sell debt) and stock prices are low (a bad time to sell equity). Also, theconversion price is generally set at 15%-20% above the current market price of the stock at thetime of issuance, so the appeal is strictly speculative.

Consider the following graph:

$Conversion Value

MarketCall Price Price

Par Value

Bond Value

TimeThere are two ways of looking at the convertible bond: first, it can always be held as a

straight bond. Since the conversion feature will allow the bond to pay a slightly lower rate ofinterest than if it were non-convertible (a straight bond), its bond value is at a discount. This is

referred to as the floor of the convertible bonds value since it can never be worth less than itsvalue as a straight bond. (See the red line.)

On the other hand, it can be viewed as if it were converted into common stock. Itsconversion value is equal to the number of shares that it is convertible into times the marketprice per share of stock.

ShareperPriceMarket*RatioConversion=ValueConversion


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Since stock prices are generally expected to increase over time, the conversion value of theconvertible bond is portrayed as increasing over time as well.

A company typically includes a call provision on a convertible bond. If an investor hadtotal discretion as to when they wanted to convert, what would motivate the investor to convert

from a bond to stock? An investor would voluntarily convert (prior to maturity) only if there wasmore income being paid to shareholders than to bondholders. In particular, assume that theconvertible bond pays an 8% coupon rate of interest. Since the typical stock today pays onlyabout a 2% dividend yield, then dividends would have to quadruple before an investor wouldvoluntarily convert the bond. The company, on the other hand can force conversion byexercising the call provision. If, for example, the conversion value of the bond was $1,150 whilethe call price was $1,050 what do you think an investor would do when the company sends aletter saying send us your bond within the next two months and well send you $1,050? Theinvestor would send the bond and say heres the bond, send me the stock (worth $1,150).Why would a company want to force conversion? In order to stop paying interest at the highrate. It will also make the debt/equity ratio look a lot better.

The advantage to the company of selling a convertible bond is that it can sell the bond ata lower rate of interest than if it were a straight bond. In addition, it is contingently selling stockat a higher price than the current market price of the stock.

Both warrants and convertibles act as sweeteners to make a bond issue more attractive.The difference is that when warrants are issued, new money (the exercise price) comes into thefirm while the debt remains outstanding and must be retired. When a convertible bond isexercised, on the other hand, the debt is converted into equity.

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HybridSecurities.doc