Convertible Securities Chapter 10 Convertible Securities

Learning Goals Understand the characteristics of convertible securities How to value convertible securities.

Introduction Fixed-income security that allows holder to convert the security into a specified number of shares of the issuing company’s common stock Two major types of convertible securities: Convertible bonds Convertible preferred stock “Equity kicker”: another name for the conversion feature that allows holder to convert the security into a specified number of shares of common stock Forced conversion: calling in of convertible bonds by the issuing firm

Conversion privilege: the conditions and specific nature of the conversion feature on convertible securities Conversion period: the time period during which a convertible issue can be converted Conversion ratio: the number of shares of common stock into which a convertible issue can be converted Conversion price: the stated price per share at which common stock will be delivered to the investor in exchange for a convertible issue

Valuation on Convertible Securities When the market price of the common stock is greater than or equal to the conversion price, the convertible derives its value from the common stock. When the market price of the common stock is below the conversion price, the convertible takes its value as a bond Due to the equity kicker, convertibles are not as interest sensitive as straight bonds.

In theory, the market price of a convertible bond should never drop below its intrinsic value. The intrinsic value is simply the number of shares being converted at par value times the current market price of common shares. Bond behaviour In-the-money : Conversion Price is < Share Price At-the-money : Conversion Price is = Share Price Out-the-money : Conversion Price is > Share Price

Conversion Ratio Conversion ratio is the number of shares of common stocks received in exchange for convertible bonds. Conversion ratio = Par Value Conversion price   Ex: Par Value is RM 1,000 and conversion price is RM25 and the market price of the stock is RM 24 while the current price of the convertible bond is RM 880 Conversion ratio = RM 1,000/RM 25 = 40 shares.

Conversion Value Conversion Value: indication of what a convertible issue would trade for if it were priced to sell on the basis of its stock value. Conversion Value = Con. Ratio x Current market price of the stock From the example: conversion value = 40 shares x RM 24 = RM 960

Conversion Equivalent Conversion Equivalent: the price at which the common stock would have to sell in order to make the convertible security worth its present market price Conversion equivalent = Current m/price of convertible bond (Conversion parity) Conversion ratio    From the above example: Conversion equivalent = RM880 = RM22 per share 40

Conversion Premium Conversion Premium: amount above the conversion value that investors are willing to pay; typically due to the higher current income provided by convertibles over common stock if the convertible bond is given the market price Conversion premium = current market price - conversion value of convertible bond if the market price of the convertible bond is not given Conversion premium = Par Value - conversion value

Conversion premium = Conversion price -market price per share Conversion premium = Conversion price -market price per share common stock Conversion premium (%) = Conversion premium ($) Conversion Value

Payback Period Payback Period: the length of time it takes for the buyer of a convertible to recover the conversion premium from the extra current income earned on the convertible Payback period = Conversion premium (in RM)______ Annual interest Annual dividend Income from the - income from the Convertible bond underlying c/stock

Benefit For Investors Convertible bonds are usually issued offering a higher yield than obtainable on the shares into which the bonds convert. Convertible bonds are safer than preferred or common shares for the investor. The purchase of convertible bonds and the short sale of the same issuer's common stock is a hedge fund strategy known as convertible arbitrage.

Benefit For Issuers Lower fixed-rate borrowing costs Locking into low fixed–rate long-term borrowing Higher conversion price than a rights issue strike price Voting dilution deferred Increasing the total level of debt gearing. Takeover paper Tax advantages

Advantages of Convertible Securities Convertible securities can reduce downside risk, Good upside potential because convertible bond must always be worth at least conversion as the price of common stock rise Current income are greater than dividends on common stock. Investing in convertible securities allows the convertible securities holder to convert his/her bond/preferred stock into common stock, thus it enables the bondholder to become stockholder. Convertible securities has unique combination of income stream from fixed-income security and chance to participate in the price appreciation of Common stock. Compared to common stock owners, convertible bond holders enjoy a yield advantages while waiting for appreciation in the stock price.

Disadvantages of Convertible Securities Investors may have to give up some potential profits in the event of forced conversion Interest rates are usually lower than the ordinary bonds there is a possibility that the market price of the common stock did not go beyond the conversion price, thus making conversion unattractive to investors. When this happens they may lose out on the opportunity for capital gain.