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ANALYSIS OF CONVERTIBLE BONDS

A convertible bond
a corporate bond with a call option to buy the common stock of the issuer. The conversion provision in a corporate bond issue grants the bondholder the right to convert the bond into a predetermined number of shares of common stock of the issuer.

A corporate bond without the conversion option - straight value

Suppose you have a 10% bond that pays semiannual coupons and will mature in 15 years. The face value is $1000 and the yield to maturity on similar bonds is 9%. The bond is also convertible with a conversion price of $100. The stock is currently selling for $110.
Straight bond value = 1081.44

Conversion ratio
The number of shares of common stock that the bondholder will receive from exercising the call option of a convertible bond or an exchangeable bond

Suppose you have a 10% bond that pays semiannual coupons and will mature in 15 years. The face value is $1000 and the yield to maturity on similar bonds is 9%. The bond is also convertible with a conversion price of $100. The stock is currently selling for $110.

Conversion ratio = 1000/100 = 10

Convertibles
The conversion price is the effective price paid for the stock

Upon conversion, the bondholder typically receives from the issuer the underlying shares. This is referred to as a physical settle. The issuer may have the choice of paying the bondholder the cash value of the underlying shares. This is referred to as a cash settle.

Most convertible bonds are callable at the option of the issuer. Some convertible bonds are putable. A hard put is one in which the convertible security must be redeemed by the issuer only for cash. A soft put is one in which the issuer has the option to redeem the convertible security for cash, common stock, subordinated notes, or a combination of the three.

MINIMUM VALUE OF A CONVERTIBLE BOND conversion value


the value of the bond if it is converted immediately. conversion value = (market price of common stock)(conversion ratio).

Suppose you have a 10% bond that pays semiannual coupons and will mature in 15 years. The face value is $1000 and the yield to maturity on similar bonds is 9%. The bond is also convertible with a conversion price of $100. The stock is currently selling for $110.
Conversion ratio = 1000/100 = 10 Conversion value = 10*110 = 1100

Convertible bonds will be worth at least as much as the straight bond value or the conversion value, whichever is greater The minimum price of a convertible bond is the greater of its conversion value or its value as a corporate bond without the conversion option - straight value

Suppose you have a 10% bond that pays semiannual coupons and will mature in 15 years. The face value is $1000 and the yield to maturity on similar bonds is 9%. The bond is also convertible with a conversion price of $100. The stock is currently selling for $110. What is the minimum price of the bond?
Straight bond value = 1081.44 Conversion ratio = 1000/100 = 10 Conversion value = 10*110 = 1100 Minimum price = $1100

market conversion price = (market price of convertible bond) / (conversion ratio). market conversion premium per share = market conversion price current market price.

Suppose you have a 10% bond that pays semiannual coupons and will mature in 15 years. The face value is $1000 and the yield to maturity on similar bonds is 9%. The bond is also convertible with a conversion price of $100. The stock is currently selling for $110. The bond market price is $1200.

Market conversion price = 1200/10 =120 Market conversion premium per share = 120 -110 = 10

market conversion premium ratio = (conversion premium per share) / (market price of common stock). The market conversion premium per share can be seen as the price of a call option.

Suppose you have a 10% bond that pays semiannual coupons and will mature in 15 years. The face value is $1000 and the yield to maturity on similar bonds is 9%. The bond is also convertible with a conversion price of $100. The stock is currently selling for $110. The bond market price is $1200.
Market conversion price = 1200/10 =120 Market conversion premium per share = 120 110 = 10 Market conversion premium ratio = 10/110 = 9.09%

CURRENT INCOME OF CONVERTIBLE BOND VERSUS STOCK


As an offset to the market conversion premium per share, investing in the convertible bond rather than buying the stock directly generally means that the investor realizes higher current income from the coupon interest paid on the convertible bond than would be received as dividends paid on the number of shares equal to the conversion ratio. Analysts evaluating a convertible bond typically compute the time it takes to recover the premium per share by computing the premium payback period (which is also known as the break-even time).

Premium payback period = Market conversion premium per share / Favorable income differential per share Favorable income differential per share = (coupon interest from bond (conversion ratio x dividend per share)) / conversion ratio. Notice that the premium payback period does not take into account the time value of money.

Suppose you have a 10% bond that pays semiannual coupons and will mature in 15 years. The face value is $1000 and the yield to maturity on similar bonds is 9%. The bond is also convertible with a conversion price of $100. The stock is currently selling for $110 and pays dividend of $5. The bond market price is $1200.
Market conversion price = 1200/10 =120 Market conversion premium per share = 120 -110 = 10 Favorable income differential per share = (100-(5*10))/10 = 5 Premium payback period = 10/5 = 2 years

DOWNSIDE RISK WITH A CONVERTIBLE BOND


The straight value of the bond as a measure of the downside risk of a convertible bond, because the price of the convertible bond cannot fall below this value. Current floor for the price of the convertible bond.

DOWNSIDE RISK WITH A CONVERTIBLE BOND


premium over straight value = (market price of the convertible bond / straight value) 1. The higher the premium over straight value, all other factors constant, the less attractive the convertible bond.

INVESTMENT CHARACTERISTICS OF A CONVERTIBLE BOND If the price of the stock is low, so that the straight value is considerably higher than the conversion value, the bond will trade much like a straight bond. Then, the convertible bond in such instances is referred to as a bond equivalent or a busted convertible

INVESTMENT CHARACTERISTICS OF A CONVERTIBLE BOND When the price of the stock is such that the conversion value is considerably higher than the straight value, the convertible bond will trade as if it were an equity instrument. (an equity equivalent )

Otherwise, hybrid security

PROS AND CONS OF INVESTING IN A CONVERTIBLE BOND

Buyer. Issuer.

Buyer
Lower return More expensive. Low coupon. Unless the interest payments for the length of ownership cover the higher price paid per share and any dividends that are forgone for the length of time.

Buyer
Call risk
callable by issuers. current market price of issuers stock undervalued enough so that selling stock directly would dilute the equity of current stockholders.

Takeover risk
the stock of the acquired company may no longer trade after a takeover

Buyer
Advantage of buying the bond
its value will likely fall less than that of stock if a firm runs into financial distress difficulties.

OPTIONS APPROACH
(i) buying a noncallable/nonputable straight bond, and (ii) buying a call option on the stock, where the number of shares that can be purchased with the call option is equal to the conversion ratio. Convertible bond value = straight value + price of the call option on the stock

A convertible bond: the issuers right to call the bond. If called, the investor can lose any premium over the conversion value that is reflected in the market price. Therefore, the analysis of convertible bonds must take into account the value of the issuers right to call the bond. This depends, in turn, future interest rate volatility, and economic factors that determine whether it is optimal for the issuer to call the bond.

binomial option pricing model can be used simultaneously to value the bondholders call option on the stock and the issuers right to call the bonds.

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