Practice investment management pim3 ch14

CHAPTER FOURTEEN CONVERTIBLE SECURITIES Practical Investment Management Robert A Strong 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  South-Western / Thomson Learning © 2004 14 - Outline  Warrants Characteristics  Pricing of Warrants  Warrants and Leverage  South-Western / Thomson Learning © 2004 14 - 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 South-Western / Thomson Learning © 2004 14 - Convertible Bonds: Characteristics par value conversion price = conversion ratio conversion conversion current = X stock price value ratio premium over market conversion conversion value = price value South-Western / Thomson Learning © 2004 14 - Pricing of Convertible Bonds Insert Table 14-1 here South-Western / Thomson Learning © 2004 14 - 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 South-Western / Thomson Learning © 2004 14 - Metamorphosis of a Convertible Bond Acts like a Stock stock price conversion price new convertible bond common stock equivalent rising stock price declining or slow rising stock price time busted convertible Acts like a Bond South-Western / Thomson Learning © 2004 14 - Pricing of Convertible Bonds  Convertible bonds should never sell for less than their conversion value  With a busted convertible, the conversion feature has little value  Convertible bonds provide for upside potential while reducing downside risk South-Western / Thomson Learning © 2004 14 - Pricing of Convertible Bonds Insert Table 14-2 here South-Western / Thomson Learning © 2004 14 - 10 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 sometimes called the break-even time South-Western / Thomson Learning © 2004 14 - 11 Calculating Premium Payback Period market conversion price = market value conversion ratio Premium payback period = market conversion price - stock price bond interest - ( conversion ratio × dividends per share ) conversion ratio South-Western / Thomson Learning © 2004 14 - 12 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 South-Western / Thomson Learning © 2004 14 - 13 Convertible Bonds: Unusual Features  Interest payments: A few convertible bonds 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 South-Western / Thomson Learning © 2004 14 - 14 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 South-Western / Thomson Learning © 2004 14 - 15 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 South-Western / Thomson Learning © 2004 14 - 16 Pricing of Warrants  The exercise price is the price at which an investor holding warrants may buy the underlying shares  When the stock price rises above the exercise 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 South-Western / Thomson Learning © 2004 14 - 17 warrant price Pricing of Warrants ue l va (= k c o t s ) e ic r p actual market value e us u l in a v m e) e ric m c u ri p m i p e n i ck is m to rc s xe (= e um m i ax m 45º 45º exercise price stock price Assumption: One warrant is required to buy one share of stock South-Western / Thomson Learning © 2004 14 - 18 Warrants and Leverage  Speculators buy warrants because of the leverage they provide South-Western / Thomson Learning © 2004 14 - 19 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  South-Western / Thomson Learning © 2004 14 - 20 Review  Warrants Characteristics  Pricing of Warrants  Warrants and Leverage  South-Western / Thomson Learning © 2004 14 - 21 ... 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