1. Convertible Securities Chapter 4 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company1 What is it? Convertibles are bonds or preferred stocks that may be converted at a specified conversion price (per share) or conversion ratio (number of shares) into the common stock of the firm issuing the securities. –There are many variations, which allow a holder to exchange, trade in, or convert the security being held into another type of security. –They are hedge-type instruments that allow investors to enjoy much of the upside potential of a riskier investment while bearing the smaller downside risk more commonly associated with investments offering less upside potential.

2. Convertible Securities Chapter 4 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company2 When is the use of this tool indicated? When the investor would like to combine an element of certainty with the opportunity for significant capital gains. –The element of certainty is achieved through a fixed interest or dividend rate and a known payment schedule. When the investor needs current cash flow that provides a higher rate of return than available from the dividends on common stock. When the investor at the same time is willing to accept a somewhat lower rate of current income than might be available on bonds and preferred stocks that do not have the conversion feature

3. Convertible Securities Chapter 4 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company3 Advantages There is a high degree of security for both principal and income. –The general credit of the issuing corporation stands behind payments. –Preferred stockholders are protected by the cumulative nature of most preferred dividends. Convertible securities offer the potential for capital growth through ownership of the common stock. –This appreciation is provided by: The conversion and actual ownership of the common stock of a corporation. The appreciation in the market value of the convertible bond or preferred stock that occurs as a result of an increase in the price of the common stock. –If the underlying stock price rises above the value of the convertible as a fixed income security, the convertible’s price will move in almost direct relation to the price of the common stock.

4. Convertible Securities Chapter 4 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company4 Example A bond convertible into 50 shares of common stock that sells for about $1,000 as a fixed income security will sell for at least $1,500 if the common stock increases in value from $20 per share to $30 per share.

5. Convertible Securities Chapter 4 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company5 Advantages The basic form offers some protection in the event that common stock prices decline. –A “floor” under the price of the convertible security is provided by the intrinsic worth of the bond or preferred stock. Convertible securities typically pay a higher rate of return in the form of interest or dividends than is available from the company’s common shares. –Many companies that issue convertible securities pay no current dividends on their common stocks.

6. Convertible Securities Chapter 4 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company6 Advantages The investor controls the form of investment and the timing of the conversion. –In some cases, a corporation may effectively force conversion by exercising the call feature common to almost all convertible securities. The change in the nature of the investment can be effected quickly and with little or no cost to the investor. –The investor merely sends the convertible security to the issuer and requests the change. –Typically, there are no fees or charges associated with the transaction.

7. Convertible Securities Chapter 4 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company7 Disadvantages Until the conversion has been made, the investor is relatively unprotected from the effects of inflation. –This is due to the fixed nature of interest payments on convertible bonds and the fixed dividend rate on convertible preferred stocks. The yields provided by convertible securities are often significantly below the yields of alternative investments. –Since convertibles provide both upside potential and downside protection, investors must pay a premium for the securities. If the price of the underlying common stock does increase substantially, the value of the convertible will never increase as much as the value of the underlying common stock because of the premium paid for the convertible.

8. Convertible Securities Chapter 4 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company8 Disadvantages Typically, convertible bonds are callable by the issuing corporation at a price slightly about their par value. –Companies can use this feature to force conversion if the price of the bond has appreciated to a point well above the call price. –This conversion may be forced earlier than the investor planned. The investor will not have recovered the premium paid to purchase the convertible, making the return less than if the underlying common stock had been purchased outright.

9. Convertible Securities Chapter 4 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company9 Example A bond convertible into 50 shares of common stock will sell for at least $1,500 if the stock is trading at $30 per share. The same bond may have a call price of only $1,080. If the issuer were to call the bond, investors would be forced to convert their bonds into common stock or face the loss of $420 per bond.

10. Convertible Securities Chapter 4 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company10 Disadvantages Convertible issues tend to be of relatively small size when compared with regular bond and stock issues. –With fewer convertibles outstanding, trading is less active and may result in a lack of liquidity when buying or selling a particular issue. Generally, convertible bonds are subordinated to all other debt issued by the firm. –Default risk is higher than for other nonconvertible debt. Because of the complex nature of convertibles as hybrid securities, a more involved and detailed selection process is necessary

11. Convertible Securities Chapter 4 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company11 Tax Implications Income received from a convertible bond or preferred stock is subject to ordinary income tax rates. Appreciation is not taxable until the investor sells the bond, preferred stock, or the common shares received on conversion. –Original issue discount on a convertible bond may be includable as it accrues. Conversion itself is not a taxable event. –The investor takes as his cost basis the price paid for the original investment. –If the conversion feature is not detachable, there is no allocation of basis to the two components of the security. Basis is carried over to the common shares.

12. Convertible Securities Chapter 4 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company12 Example Nancy Manzi purchased a convertible bond for $800. She later converted the bond into 40 shares of the issuing company’s common stock. Nancy’s cost basis for those 40 shares of common stock is $800, a carryover of her original investment. This results in a cost basis for the common stock of $20 per share ($800 / 40 shares).

13. Convertible Securities Chapter 4 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company13 Tax Implications Profits or losses on the sale of a convertible bond or preferred stock, or on the maturity of a convertible bond, are treated as capital gains or losses. –Market discount and original issue discount realized on sale or maturity of a bond may have to be treated as interest. –Long-term capital gains are generally taxable at a maximum rate of 15%. –Capital losses may be used to offset only capital gains and up to $3,000 of ordinary income per year.

14. Convertible Securities Chapter 4 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company14 Alternatives Convertible bonds with a premium put –Offer additional downside protection –Issued at face value –Include a put option that allows the investor to redeem the bonds for cash at a premium relative to the bonds’ face value at a future date –Typically pay lower interest than non-convertibles Mutual funds specializing in convertible securities Bond issues with equity warrants –These are essentially just convertible bonds with a detachable conversion feature. –If the warrant is detachable, the bond and warrant will be treated for tax purposes as separate instruments.

15. Convertible Securities Chapter 4 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company15 Alternatives Investors could also “package” their own form of convertible by combining stock purchase warrants or call options with straight bonds. –Stock purchase warrant: An option to buy stock at a stated price for a given period of time. Pays no income Allows investors to determine the timing of their purchase Offers the opportunity for appreciation Provides leverage in that the exercise price of the warrant is generally fixed in the same manner as the conversion price of a convertible bond or convertible preferred stock. –Satisfies the investors twin objectives of capital gain potential (through the warrant) and current income (through the straight bond).

16. Convertible Securities Chapter 4 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company16 Where and How do I get it? Full service brokerage firms –Investors can purchase directly by calling and placing an order. Discount brokerage firms –Many banks and thrift institutions also provide discount brokerage services. Mutual funds –Offer the benefits of diversification and professional management –Eliminate the need for the investor to analyze various bonds and to select the most attractive at any given time.

17. Convertible Securities Chapter 4 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company17 What fees or other acquisition costs are involved? Brokerage fees on the purchase of the convertible bonds –Similar to those paid in buying regular bonds –Approximately $5 to $20 per bond, depending on: The total value of the transaction The number of bonds purchased Whether or not a discount broker is used –Some firms will charge a minimum fee of $30 regardless of the number of bonds being bought or sold

18. Convertible Securities Chapter 4 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company18 How do I select the best of its type? Look for a record of increasing earnings for at least the past 5 years and assets well in excess of the face value of the bonds. For a new issue, the investment banking firm that underwrites the issue and offers it to the public should be a member of a major stock exchange. Investors may prefer convertibles offered by companies in growth industries. –Companies experiencing growth in earnings per share (EPS) are likely to have their stock price increase as well. –Buyers looking to convert their bonds into stock or sell the bonds at an appreciated value should consider the gain in value caused by growth in EPS, as the convertible bonds will also increase in price.

19. Convertible Securities Chapter 4 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company19 How do I select the best of its type? Calculate the payback period –Payback period indicates how long it will take the investor to recoup the premium paid for the bond over its conversion value from the added yield of the convertible security. 1.Conversion Ratio = Bond face value ($1,000) divided by conversion price 2.Conversion Value = Conversion ratio multiplied by the current market value of one share of stock 3.Conversion Premium = The amount the convertible price exceeds the conversion value (% by dividing the difference by the conversion value) 4.Yield Advantage = The amount by which the current yield on the bond exceeds the yield on the common 5.Payback Period = The premium divided by the yield advantage

20. Convertible Securities Chapter 4 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company20 How do I select the best of its type? The interest paid on the convertible bond should be within two percentage points of the rate paid on similar quality, nonconvertible bonds. –Investors should not sacrifice too much in terms of current income in exchange for the speculative feature of converting to common stock in the future.

21. Convertible Securities Chapter 4 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company21 Where can I find out more about it? Statistical rating agencies –Standard & Poor’s (www.standardandpoors.com)www.standardandpoors.com –Moody’s Investors Service (www.moodys.com)www.moodys.com Various publications specializing in convertible bonds –Value Line Convertible Survey, Arnold Bernhard & Company, Inc., 711 Third Avenue, New York, NY 10017 Major brokerage firms Newspapers that quote bonds daily –The New York Times –The Wall Street Journal Other internet sources –Bondsonline (www.bondsonline.com)www.bondsonline.com –Convertbond (www.convertbond.com)www.convertbond.com