CONVERTIBLE SECURITIES CHAPTER FOURTEEN Practical Investment Management Robert A. Strong

South-Western / Thomson Learning © Outline  Convertible Bonds  Characteristics  Pricing of Convertible Bonds  Why Companies Issue Convertible Bonds  Unusual Features  Convertible Preferred Stock  Background on Preferred Stock  The Conversion Feature

South-Western / Thomson Learning © Outline  Warrants  Characteristics  Pricing of Warrants  Warrants and Leverage

South-Western / Thomson Learning © 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.

South-Western / Thomson Learning © Convertible Bonds: Characteristics conversion value conversion ratio current stock price = X conversion price = par value conversion ratio premium over conversion value = - market price conversion value

South-Western / Thomson Learning © Pricing of Convertible Bonds Insert Table 14-1 here.

South-Western / Thomson Learning © 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.

South-Western / Thomson Learning © Metamorphosis of a Convertible Bond stock price time conversion price common stock equivalent rising stock price Acts like a Stock busted convertible declining or slow rising stock price Acts like a Bond new convertible bond

South-Western / Thomson Learning © 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.

South-Western / Thomson Learning © Pricing of Convertible Bonds Insert Table 14-2 here.

South-Western / Thomson Learning © 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.

South-Western / Thomson Learning © Calculating Premium Payback Period Premium payback period =

South-Western / Thomson Learning © 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 have to repay the debt.

South-Western / Thomson Learning © 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.

South-Western / Thomson Learning © 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.

South-Western / Thomson Learning © 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 non-detachable.

South-Western / Thomson Learning ©  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

South-Western / Thomson Learning © Pricing of Warrants warrant price stock price actual market value 45º maximum value (= stock price) exercise price 45º minimum value (= stock price minus exercise price) Assumption: One warrant is required to buy one share of stock.

South-Western / Thomson Learning ©  Speculators buy warrants because of the leverage they provide. Warrants and Leverage

South-Western / Thomson Learning © Review  Convertible Bonds  Characteristics  Pricing of Convertible Bonds  Why Companies Issue Convertible Bonds  Unusual Features  Convertible Preferred Stock  Background on Preferred Stock  The Conversion Feature

South-Western / Thomson Learning © Review  Warrants  Characteristics  Pricing of Warrants  Warrants and Leverage