Business
Convertibles
Convertibles are hybrid securities that can be converted into a predetermined number of common stock shares. They offer investors the potential for capital appreciation through stock price increases, while also providing downside protection through their fixed-income characteristics. Convertibles are often issued by companies as a way to raise capital at a lower cost than issuing traditional debt or equity.
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8 Key excerpts on "Convertibles"
eBook - PDF- (Author)
- 2022(Publication Date)
- Wiley(Publisher)
7. CONVERTIBLE BONDS • describe contingency provisions affecting the timing and/or nature of cash flows of fixed-income securities and whether such provisions benefit the borrower or the lender A convertible bond is a hybrid security with both debt and equity features. It gives the bond- holder the right to exchange the bond for a specified number of common shares in the issuing company. Thus, a convertible bond can be viewed as the combination of a straight bond (option-free bond) plus an embedded equity call option. Convertible bonds can also include additional provisions, the most common being a call provision. From the investor’s perspective, a convertible bond offers several advantages relative to a non-convertible bond. First, it gives the bondholder the ability to convert into equity in case of share price appreciation, and thus participate in the equity upside. At the same time, the bond- holder receives downside protection; if the share price does not appreciate, the convertible bond offers the comfort of regular coupon payments and the promise of principal repayment at maturity. Even if the share price and thus the value of the equity call option decline, the price of a convertible bond cannot fall below the price of the straight bond. Consequently, the value of the straight bond acts as a floor for the price of the convertible bond. Because the conversion provision is valuable to bondholders, the price of a convertible bond is higher than the price of an otherwise similar bond without the conversion provision. Similarly, the yield on a convertible bond is lower than the yield on an otherwise similar non-convertible bond. However, most convertible bonds offer investors a yield advantage; the coupon rate on the convertible bond is typically higher than the dividend yield on the underlying common share. From the issuer’s perspective, convertible bonds offer two main advantages.
eBook - PDF- Laurence Booth, Ian Rakita(Authors)
- 2020(Publication Date)
- Wiley(Publisher)
Although the underlying security is different, the conversion fea- tures operate in an identical manner, and for convenience we will discuss convertible bonds. Note that due to their similarity, both convertible bonds and preferred shares are traded on the Toronto Stock Exchange. As described in Chapter 6, convertible bonds are bonds that can be converted into a specified number of common shares at the option of the bondholder. In many ways, they are similar to bonds with warrants. The key difference is that when convert- ibles are converted, the bonds or preferred shares are exchanged for common shares and are no longer outstanding, whereas for debt with warrants attached, the debt remains outstanding and the exercise price is paid in cash. This means that the firm does not get any new financing when Convertibles are converted; all that happens is that the debt is converted into common shares. In contrast, with warrants the firm gets new financing from the sale of new shares at the exercise price. However, even though they get no additional financing, firms issue con- vertibles because the conversion does change the firm’s capital structure by increasing the amount of common equity and reducing either debt or preferred shares. As we will discuss in Chapter 21, this increases the firm’s financial flexibility and allows it to issue more debt in the future. On June 3, 2015, the Financial Post reported the data shown in Table 19.5 for three convertible bonds outstanding in Canada. Like companies offering warrants, companies that issue convertible bonds tend to be high risk. The first company listed in Table 19.5 is 5N Plus Inc., which is a small specialty metals company headquartered in Montreal with a market value of barely $100 million. 5N Plus has a convertible bond with a 5.75-percent cou- pon selling for $85. These bonds have just four years to maturity, and a yield to maturity of 10.36 percent, since they are selling at a $15 discount to their par value.
- Moorad Choudhry(Author)
- 2004(Publication Date)
- Butterworth-Heinemann(Publisher)
The other disad-vantages of holding Convertibles are only apparent in hindsight: if the issuer's share price does not appreciate, the investor will have accepted a below-market coupon level for the life of the bond, and possibly a drop in the price of the bond below its issue price. There a range of investor classes that may be interested in holding Convertibles at one time or another. These include equity fund managers who are currently bearish of the market: purchasing Convertibles allows them an element of downside market protection, 176 Part II: Corporate Debt Markets whilst still enabling them to gain from upside movements. Equity managers who wish to enhance the income from their portfolios may also be interested in Convertibles. For bond fund managers, Convertibles provide an opportunity to obtain a limited exposure to the growth potential and upside potential associated with an option on equities. Selected bibliography and references Calamos, J ., Convertible Securities , McGraw-Hill, 1998 Connolly, K., Pricing Convertible Bonds , Wiley, 1998 Fabozzi, F., Bond Markets, Analysis and Strategies , Prentice Hall, 1991 Kitter, G., Investment Mathematics for Finance and Treasury Professionals , Chapter 6, John Wiley and Son, 1999 Chapter 7: Convertible Bonds I 177 8 Convertible Bonds II In the previous chapter we reviewed convertible bond instruments and the features that differentiated them from conventional fixed interest bonds. In this chapter we consider the pricing and valuation of these securities. 8.1 Traditional valuation methodology Let us consider another hypothetical security issued by ABC plc, a 20-year convertible bond with a coupon of 8%. `One' bond has a nominal amount of £100 and may be converted into 10 ordinary shares of ABC plc. In November 1999 the bond is trading at £102 and the underlying shares at £2.50. In 1999 the company paid a dividend of £0.08 per share, a dividend yield of 3.20%.
eBook - PDFBasic Finance
An Introduction to Financial Institutions, Investments, and Management
- Herbert Mayo, , , (Authors)
- 2018(Publication Date)
- Cengage Learning EMEA(Publisher)
264 PART 3 Investments Review Objectives Problems Now that you have completed this chapter, you should be able to 1. Enumerate the features of convertible securities (pp. 253–254). 2. Calculate the value of a convertible security as stock (pp. 254–255). 3. Calculate the value of a convertible security as debt (pp. 256–248). 4. Describe the premiums paid for a convertible bond (pp. 259–261). 5. Explain why a convertible security is always callable and when a company may call the security (pp. 262–263). 6. Determine what affects the return on an investment in a convertible (pp. 262–263). 1. Given the following information concerning a convertible bond: Principal: $1,000 Coupon: 5 percent Maturity: 15 years Call price: $1,050 Conversion price: $37 (that is, 27 shares) Market price of the common stock: $32 Market price of the bond: $1,040 a. What is the current yield of this bond? b. What is the value of the bond based on the market price of the common stock? c. What is the value of the common stock based on the market price of the bond? d. What is the premium in terms of stock that the investor pays when he or she purchases the convertible bond instead of the stock? e. Nonconvertible bonds are selling with a yield to maturity of 7 percent. If this bond lacked the conversion feature, what would the approximate price of the bond be? Summary A convertible bond is a debt instrument that may be converted at the owner’s option into stock. The value of the bond depends on the value of the stock into which the bond may be converted and on the value of the bond as a debt instrument. As the price of the stock rises, so does the value of the convertible bonds. Since a convertible bond’s price rises with the price of the stock, the bond offers you an opportunity for capital gains. The bond pays interest income and its value as a debt instrument sets a floor on the bond’s price.
No longer available |Learn moreIntermediate Accounting
Reporting and Analysis
- James Wahlen, Jefferson Jones, Donald Pagach, , James Wahlen, Jefferson Jones, Donald Pagach(Authors)
- 2019(Publication Date)
- Cengage Learning EMEA(Publisher)
• The company wants to increase its debt and finds the conversion fea-ture necessary to make the bonds sufficiently marketable at a reason-able interest rate. • The company may wish to issue lower risk convertible debt now, while giving bond-holders an option on the upside of the company’s common stock. Several other factors motivate companies to issue convertible bonds rather than com-mon stock. For example, a company may wish to: • avoid potential downward price pressures on its stock which could result from a large new issue of common stock • avoid the direct sale of common stock when it believes its stock currently is under-valued in the market • penetrate that segment of the capital market that is unwilling or unable to partici-pate in a direct common stock issue • minimize the costs associated with selling securities For similar reasons, companies may issue convertible preferred stock (discussed in Chapter 15). In this chapter, we focus only on accounting for convertible bonds. Recording the Issuance Conceptually, there are two methods for recording the issu-ance of convertible debt. The company could attribute part of the proceeds from the sale of the security to the conversion privilege and allocate this amount to shareholders’ equity, or the company could treat the issue solely as debt. Advocates of the first position argue that because both the conversion feature and the right to receive interest are valuable to an investor, the conversion feature often car-ries a lower interest rate or a higher selling price (or both) than might otherwise have been available. Because the conversion feature is valuable, an amount equal to the dif-ference between the price at which the bonds might have been sold without the conver-sion privilege and the actual issue price should be allocated to additional paid-in capital. © ROBERT BROWN STOCK/SHUTTERSTOCK.COM Copyright 2020 Cengage Learning.
eBook - ePub- (Author)
- 2021(Publication Date)
- Wiley(Publisher)
So far, we have discussed bonds for which the exercise of the option is at the discretion of the issuer (callable bond), at the discretion of the bondholder (putable bond), or set through a pre-defined contractual arrangement (capped and floored floaters). What distinguishes a convertible bond from the bonds discussed earlier is that exercising the option results in the change of the security from a bond to a common stock. This section describes defining features of convertible bonds and discusses how to analyze and value these bonds.10.1 . Defining Features of a Convertible Bond
A convertible bond presents the characteristics of an option-free bond and an embedded conversion option, which gives bondholders the right to convert their debt into equity during the conversion period at a pre-determined conversion price .Investors usually accept a lower coupon for convertible bonds than for otherwise identical non-convertible bonds because they can participate in the potential upside through the conversion mechanism that allows the bondholders to convert their bonds into shares at a cost lower than market value. The issuer benefits from paying a lower coupon. In case of conversion, an added benefit for the issuer is that it no longer has to repay the debt that was converted into equity.However, what might appear as a win–win situation for both the issuer and the investors is not a “free lunch” because the issuer’s existing shareholders face dilution in case of conversion. In addition, if the underlying share price remains below the conversion price and the bond is not converted, the issuer must repay the debt or refinance it, potentially at a higher cost. If conversion is not achieved, the bondholders will have lost interest income relative to an otherwise identical non-convertible bond that would have been issued with a higher coupon and would have thus offered investors an additional spread.
eBook - PDFDerivative Instruments
A Guide to Theory and Practice
- Brian Eales, Moorad Choudhry(Authors)
- 2003(Publication Date)
- Butterworth-Heinemann(Publisher)
Convertible bonds are often issued with features which involve more than one currency. In the indenture, for example, the shares may be denominated in one currency but the bond redeemable in another. Under such a regime the bond's price will reflect not only movements in yields but also movements in the foreign exchange markets. It is clear that this type of instrument brings with it additional risks as well as potential gains. A good exposition of the way in which such Convertibles can be priced appears in Connolly (1998). 12.3.1 Convertible bond credit spreads The main concentration of this chapter has been on the equity and bond characteristics that the instrument offers. The time has now come to examine credit aspects. This can be achieved by breaking down the bond into its component parts and structuring an asset swap to handle each identified exposure. Scenario 1 A 5.00% convertible bond with two years to maturity is purchased and held in a portfolio by a fixed income fund manager attracted by the possibility of gaining a relatively safe investment but with the good upside potential offered by the equity component of the bond. The fund manager realises at this point that the equity component has performed well since its purchase and he/she wishes to lock into the equity gains without converting. This ``locking-in'' could be achieved by writing a call option and buying a put option with a strike price that reflects the current price of the underlying equity. If exchange-based options are available they could be used but in their absence OTC options would be a substitute. Alternatives to this would be to short a USF ± if available ± or use CFDs. Up to a point this effectively covers movements up or down in the value of the share price leaving the overall position flat. Figure 12.13 illustrates how this position is hedged.
eBook - PDFEntrepreneurial Finance
Venture Capital, Deal Structure & Valuation, Second Edition
- Janet Kiholm Smith, Richard L. Smith(Authors)
- 2019(Publication Date)
- Stanford Business Books(Publisher)
In the following discus-sion we consider the basic categories of terms and provisions contained in both the term sheet and the investment agreement. Investment Form By far the most common type of security that VCs use to make the investment is convertible preferred stock. In contrast, the entrepreneur holds straight eq-uity and is the residual claimant on the cash flows of the firm. To attract in-vestment, the entrepreneur can signal confidence by agreeing to compensate the investor with preferred stock instead of common. Holders of convertible securities generally have the right to convert at any time, but there are also conditions when conversion is automatic, such as when a company goes public. Preferred stock investors are often entitled to receive dividends, and debt investors are entitled to receive interest. However, because 140 Chapter Four entrepreneurial ventures are cash-constrained, dividends and interest payments are normally accrued rather than being paid out. Accrued dividends and interest are reflected as increases in the amount invested. In addition, investments in the venture may be “sweetened” with warrants that would enable the investor to acquire additional shares at a prespecified price. Also, the entrepreneur and employees may be compensated partly in the form of stock options. TABLE 4.1 Standard provisions of a VC term sheet for convertible preferred investment Terms and Provisions Description and Purpose Amount Raised, Price per Share, Pre-Money Valuation, Capitalization Describes the general parameters of the financing round. Pre-money valuation is the value implied by the price per share before including the proceeds of the round. Capitalization describes the VC structure, including preferred shares used in the funding round. Dividends for Preferred Shares Describes how dividends will accrue to preferred shareholders and timing and con-ditions under which dividends are paid.
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