Convertible Bonds

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Convertible Bonds:

Convertible Bonds The Professional Risk Managers’ Guide to Financial Instruments

Definition :

Definition A convertible Security – any security capable of being converted Convertible Security – is also defined as “synthetic convertibles” which may be created by combining separate securities that in combination possess two principle characteristic of a true convertible security: an income stream or accretion and the right to acquire equity securities

Definition:

Definition Convertibles – are hybrid investment instruments. They are called hybrid because most can be converted at the user’s choice into other investments, most often common shares of stock. Convertibles share relative safety of fixed-income investments (bonds) while also being exposed to underlying stock’s potential gains. Example: Convertible bonds and preferred stocks

Few more facts to consider before buying convertibles::

Few more facts to consider before buying convertibles: They are usually debentures . They are usually subordinated debentures . Default risk aside, most convertibles are callable by the issuer at short notice. If the issuer exercises this right to buy back the convertible, the investor usually has a limited time in which to convert. This is known as a Forced conversion . You pay a price for these hybrid securities. Conversion Premium – represents the distance the stock price has to climb to reach the break-even point for converting the bond.

Other instruments related to convertible bonds::

Other instruments related to convertible bonds: Convertible preferred shares – operate in a very similar fashion with convertible bonds except for 3 main difference: The par amount of a convertible bond is typically a round number Rather than a coupon, these typically pay a dividend. The dividend is set as a fixed amount, very similar to a fixed-rate coupon Convertible bonds rank senior to shares (but typically junior to other bonds) in the event of liquidation. Preferred shares rank equally with the common stock. Exchangeable bond – this is convertible to common stock of another company (not the issuer).

Characteristics of Convertibles:

Characteristics of Convertibles Relationship with stock price It has the elements of: Fixed income, equity and derivatives Call and Put features

Relationship with Stock Price:

Relationship with Stock Price

Relationship with Stock Price:

Relationship with Stock Price The convertible is worth more than a similar bond which is not convertible because it has an additional right of conversion which will have a positive value. The convertible is worth more than the stock price times the conversion ratio, otherwise investors could earn arbitrage profits by purchasing convertibles and immediately converting them to stock. Therefore, the convertible bond’s price must be above the “bond floor” and “equity floor”

Relationship with Stock Price:

Relationship with Stock Price Convertible bonds have different characteristics and risk profiles in five distinct regions : Distressed Region – When the stock is very low, the company is in dire threat of bankruptcy. Credit spreads widen and the company paper is treated like “junk debt” Bond Region (out-of-the-money convertibles) – When the stock price takes values in this range, the company’s credit rating is deemed stable. The convertible bond behaves very much like a fixed-income instrument. Hybrid Region (at-the-money convertibles) – In this region, the bond behaves like a true hybrid instrument. The Convertible bond’s price chart is convex. Equity Region – (in-the-money convertibles) – In this region, the convertible bond moves in line with the stock. Very High Stock prices (discount-to-parity convertibles) – the small discount of the convertible bond price to the stock price is normally because the bond is less liquid than the stock.

Call and Put Features:

Call and Put Features Convertible bonds and debentures are changeable at the holder’s option into shares of the issuing corporation. In most new issues, the bonds or debentures are “callable” by the issuer, usually at a premium to their issue price. In the case of convertible bonds, we distinguish between 2 types of call protection: Hard call protection: this means that the bond cannot be called until a certain date Soft call protection: this means the bond could be called by the issuer but only if the share price exceeds a certain threshold. Typically, the threshold is well above the call price.

Example 1:

Example 1 A convertible might have a hard call protection for 2 yrs. After that it is callable at par but only if the share price is above $24. Assuming a conversion ratio of 50 shares per bond, the conversion value of the bond when it is called is at least: 50 x $24 = $1,200 There is a concept of a “notice period”. The investor may decide whether to accept the call or convert to shares.

Capital Structure Implications (For Banks):

Capital Structure Implications (For Banks) Issuing preferred shares has profound implications on the capital structure of a bank. Preferred shares – are treated as equity capital even though dividend-income is a tax-deductible expense. In US, the Federal Reserve allows perpetual preferred stock to be included in Tier 1 capital . Redeemable preferred stock and cumulative perpetual preference shares are typically included in Tier 2 capital .

Capital Structure Implications (For Banks):

Capital Structure Implications (For Banks) Tier 1 capital – is core capital, this includes equity capital and disclosed reserves. Equity capital includes instruments that CAN’T be redeemed at the option of the holder. Tier 2 capital – is secondary bank capital that includes items such as undisclosed reserves, general loss reserves, subordinated term debt and more.

Capital Structure Implications (For Banks):

Capital Structure Implications (For Banks) Regulators impose certain ratios that must be maintained at all times. The Accord requires these banks to “hold capital (sum of tier 1 and tier 2) equal to at least 8% of a basket of assets measured in different ways according to their riskiness.” In addition, at least half of the bank’s capital must be in tier 1. Qualifying hybrid instruments can be included in Tier 2 capital, along with long-term subordinated debt and reserves.

Mandatory Convertibles:

Mandatory Convertibles Mandatory Convertibles – are instruments where the holder of the note must convert at the predefined ratio if he holds it to maturity. There are many types of mandatory convertible instruments, including debt exchangeable to common stock (DECS) and preferred equity redemption cumulative stock (PERCS)

Debt Exchangeable to Common Stock (DECS):

Debt Exchangeable to Common Stock ( DECS ) also known as: Preferred equity participation securities, Preferred redeemable increased dividend equity securities, Mandatory adjustable redeemable convertible securities, Stock appreciation income linked securities, Threshold appreciation price securities, Trust issued mandatory exchange securities, or Trust automatic common exchange securities;

Preferred Equity Redemption Cumulative Stock (PERCS):

Preferred Equity Redemption Cumulative Stock (PERCS) also known as: Mandatory conversion premium dividend preferred stock, Targeted growth enhanced term securities, Yield enhanced stock, Equity linked debt securities, Performance equity-linked-redemption quarterly-pay securities, Yield enhanced equity linked debt securities, And, in Europe, reverse convertibles.

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