Practice investment management pim3 ch14

 The number of shares the bondholder receives per $1,000 par value when converting the bond is called the conversion ratio... Convertible Bonds: Characteristicsconversion value = X con

CONVERTIBLE SECURITIES

CHAPTER FOURTEEN

Practical Investment Management

 Convertible Bonds

 Characteristics

 Pricing of Convertible Bonds

 Why Companies Issue Convertible Bonds

 Unusual Features

 Convertible Preferred Stock

 Background on Preferred Stock

 The Conversion Feature

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.

Convertible Bonds: Characteristics

conversion

value = X conversion ratio stock price current

conversion price = par value

conversion ratio

premium over

conversion value = - market price conversion value

Pricing of Convertible Bonds

Insert Table 14-1 here.

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.

Metamorphosis of a Convertible Bond

Acts like a Stock

busted convertible

declining or slow rising stock price

Acts like a Bond

new convertible

bond

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.

Pricing of Convertible Bonds

Insert Table 14-2 here.

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.

Calculating Premium Payback Period

ratio

conversion

value

market price

conversion market 

ratio conversion

share per

dividends ratio

conversion -

interest bond

price stock

price conversion

-market



Premium payback period =

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

Convertible Bonds: Unusual Features

 Interest payments: A few convertible bonds

do 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.

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.

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

 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.

Pricing of Warrants

 Speculators buy warrants because of the

leverage they provide.

Warrants and Leverage

 Convertible Bonds

 Characteristics

 Pricing of Convertible Bonds

 Why Companies Issue Convertible Bonds

 Unusual Features

 Convertible Preferred Stock

 Background on Preferred Stock

 The Conversion Feature