CONVERTIBLE BOND • Convertible bond have been issued and traded since 1880s

• A convertible bond is a bond that can be converted into a predetermined amount of the company's equity at certain times during its life, usually at the discretion of the bondholder.

• Convertible bonds, or converts, give the holder the option to exchange the bond for a predetermined number of shares in the issuing company.

• It is a hybrid security with debt and equity

•  A convertible bond typically has a coupon rate lower than that of similar non-convertible debt

•  The investor receives the potential upside of conversion into equity while protecting downside with cash flow from the coupon payments and the return of principal upon maturity

• These properties lead naturally to the idea of convertible arbitrage, where a long position in the convertible bond is balanced by a short position in the underlying equity.

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Convertible bonds

• Various features in convertible bonds• Issuance of convertibles - perspectives of corporate treasurers

- conversion into shares- call (hard and soft provisions)

- put - reset on conversion number

. Decomposition of convertibles into different components• Valuation of convertibles

- interest rate sensitivities (duration analysis)- binomial tree calculations

Bondholder has the right to convert the bond into common shares at some contractual price (conversion number may change over time).

Conversion value: stock price x conversion numberConversion premium: (bond price – conversion value) / conversion valueBond floor value: sum of present value of coupon and par

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Analytics of convertible bonds figures (hypothetical figures)

stock price $30.00 per sharestock dividend $0.50 per shareconvertible market price $1,000coupon rate 7.00%maturity 20 yearsconversion price $36.37

Stock dividend yield = annual dividend rate / current stock price

= $0.50 / $30.00 = 1.67%

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Conversion ratio= number of shares for which one bond may be exchanged= par / conversion price = $1,000 / $36.37 = 27.50 shares

Conversion value= equity value or stock value of the convertible= stock price x conversion ratio= $30.00 x 27.50 = $825.00

Conversion premium= (convertible price – conversion value) / conversion value= ($1,000 – $825) / $825.00 = 21.21%

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Types of companies as convertible issuers

Companies that are characterized by strong performing, high-visibility, sub-investment grade, high-growth potential have comparative advantage in the convertible market versus the fixed income market.

• They lack a long-term track record and have volatile capital structures – high coupon must be offered.

• They can transform the high volatility into a benefit since the warrant is more expensive.

• When the company grows, they may call the bonds. This in turn will strengthen the company’s equity base at the moment when it is most needed.

Analysis of a convertible bond• Conversion value • Minimum value of a convertible bond • Market conversion price • Market conversion premium per share • Market conversion premium ratio• Downside risk with a convertible bond • Upside potential of a convertible bond