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Companies with poor credit ratings often issue convertibles to lower the yield necessary to sell their debt securities. Some financially weak companies will issue convertibles just to reduce their costs of financing. Bonds have advantages over common and preferred stock to a corporation planning to raise new capital.
Companies with poor credit ratings often issue convertibles to lower the yield necessary to sell their debt securities. Some financially weak companies will issue convertibles just to reduce their costs of financing. Bonds have advantages over common and preferred stock to a corporation planning to raise new capital.
Companies with poor credit ratings often issue convertibles to lower the yield necessary to sell their debt securities. Some financially weak companies will issue convertibles just to reduce their costs of financing. Bonds have advantages over common and preferred stock to a corporation planning to raise new capital.
Dr D S Prasad Pros and cons There are pros and cons to the use of convertible bonds as a means of financing by corporations. One of several advantages of this delayed method of equity financing is a delayed dilution of common stock and earnings per share (EPS). Another is that the company is able to offer the bond at a lower coupon rate - less than it would have to pay on a straight bond. The rule usually is that the more valuable the conversion feature, the lower the yield that must be offered to sell the issue; the conversion feature is a sweetener. Advantages of Debt Financing Regardless of how profitable the company is, convertible bondholders receive only a fixed, limited income until conversion. This is an advantage for the company because more of the operating income is available for the common stockholders. The company only has to share operating income with the newly converted shareholders if it does well. Typically, bondholders are not entitled to vote for directors; voting control is in the hands of the common stockholders. Advantages of Debt Financing Thus, when a company is considering alternative means of financing, if the existing management group is concerned about losing voting control of the business, then selling convertible bonds will provide an advantage, although perhaps only temporarily, over financing with common stock. In addition, bond interest is a deductible expense for the issuing company, so for a company in the 30% tax bracket, the federal government in effect pays 30% of the interest charges on debt. Thus, bonds have advantages over common and preferred stock to a corporation planning to raise new capital. What Bond Investors Should Look For? Companies with poor credit ratings often issue convertibles in order to lower the yield necessary to sell their debt securities. The investor should be aware that some financially weak companies will issue convertibles just to reduce their costs of financing, with no intention of the issue ever being converted. As a general rule, the stronger the company, the lower the preferred yield relative to its bond yield. What Bond Investors Should Look For? There are also corporations with weak credit ratings that also have great potential for growth. Such companies will be able to sell convertible debt issues at a near-normal cost, not because of the quality of the bond but because of the attractiveness of the conversion feature for this "growth" stock. When money is tight and stock prices are growing, even very credit-worthy companies will issue convertible securities in an effort to reduce their cost of obtaining scarce capital. What Bond Investors Should Look For? Most issuers hope that if the price of their stocks rise, the bonds will be converted to common stock at a price that is higher than the current common stock price. By this logic, the convertible bond allows the issuer to sell common stock indirectly at a price higher than the current price. From the buyer's perspective, the convertible bond is attractive because it offers the opportunity to obtain the potentially large return associated with stocks, but with the safety of a bond. The Disadvantages of Convertible Bonds There are some disadvantages for convertible bond issuers, too. One is that financing with convertible securities runs the risk of diluting not only the EPS of the company's common stock, but also the control of the company. If a large part of the issue is purchased by one buyer, typically an investment banker or insurance company, conversion may shift the voting control of the company away from its original owners and toward the converters. This potential is not a significant problem for large companies with millions of stockholders, but it is a very real consideration for smaller companies, or those that have just gone public. Other disadvantages Many of the other disadvantages are similar to the disadvantages of using straight debt in general. To the corporation, convertible bonds entail significantly more risk of bankruptcy than preferred or common stocks. Furthermore, the shorter the maturity, the greater the risk. Finally, note that the use of fixed-income securities magnifies losses to the common stockholders whenever sales and earnings decline; this is the unfavorable aspect of financial leverage. Indenture provisions The indenture provisions (restrictive covenants) on a convertible bond are generally much more stringent than they are either in a short-term credit agreement or for common or preferred stock. Hence, the company may be subject to much more disturbing and crippling restrictions under a long-term debt arrangement than would be the case if it had borrowed on a short-term basis, or if it had issued common or preferred stock. Finally, heavy use of debt will adversely affect a company's ability to finance operations in times of economic stress. As a company's fortunes deteriorate, it will experience great difficulties in raising capital. Furthermore, in such times investors are increasingly concerned with the security of their investments, and they may refuse to advance funds to the company except on the basis of well- secured loans. A company that finances with convertible debt during good times to the point where its debt/assets ratio is at the upper limits for its industry simply may not be able to get financing at all during times of stress. Thus, corporate treasurers like to maintain some "reserve borrowing capacity". This restrains their use of debt financing during normal times. Why Companies Issue Convertible Debt? The decision to issue new equity, convertible and fixed-income securities to raise capital funds is governed by a number of factors. One is the availability of internally generated funds relative to total financing needs. Such availability, in turn, is a function of a company's profitability and dividend policy.
Why Companies Issue Convertible Debt? Another key factor is the current market price of the company's stock, which determines the cost of equity financing. Further, the cost of alternative external sources of funds (i.e., interest rates) is of critical importance. The cost of borrowed funds, relative to equity funds, is significantly lowered by the deductibility of interest payments (but not of dividends) for federal income tax purposes.
Why Companies Issue Convertible Debt? In addition, different investors have different risk-return tradeoff preferences. In order to appeal to the broadest possible market, corporations must offer securities that interest as many different investors as possible. Also, different types of securities are most appropriate at different points in time. Conclusion Used wisely, a policy of selling differentiated securities (including convertible bonds) to take advantage of market conditions can lower a company's overall cost of capital below what it would be if it issued only one class of debt and common stock. However, there are pros and cons to the use of convertible bonds for financing; investors should consider what the issue means from a corporate standpoint before buying in.
The Difference Between Warrants & Convertible Securities Two common types of attractive investments are warrants and convertible securities. A stock warrant gives investors the right to purchase the underlying security for a particular price. Convertible securities give investors the ability to convert the security into the companys common stock. Warrants and convertibles possess many variables. Investors deciding whether to invest in warrants or convertibles should understand the difference in features, advantages and disadvantages of both types of securities before making an investment decision.
Understanding Warrants
Investors who purchase warrants inherit the right to purchase the underlying stock or bond at a predetermined price and time. Investors are not obligated to purchase the underlying asset. Unlike convertible securities, investors who trade warrants must pay additional money to obtain the companys common stock. The time horizon of warrants varies, but many warrants are held for several years. The value of a warrant is made up of two components time and intrinsic value. The longer time left until expiration, the greater the value of the warrant. Intrinsic value relates to when the market share of the underlying asset is greater than the exercise price.
Pros and Cons of Warrants
A primary advantage of investing in warrants is that investors can potentially earn large returns with only a small amount of money used to purchase the warrant contract. Warrants offer investors diversity through a variety of underlying assets included in warrant contracts. Warrants are liquid assets, which is beneficial if the investor chooses to sell the contract instead of exercising the warrant. A disadvantage of investing in warrants is that you do not enjoy the benefits of stock ownership until you purchase the underlying asset. A warrant is a risky investment, and becomes worthless if the market value of the asset declines lower than the exercise price.
Understanding Convertible Securities
A company without access to bank financing and other traditional financing options may issue convertibles in an effort to raise quick capital. Convertible securities are longer-term investments than warrants, and are usually issued as bonds or preferred stocks that investors can convert to a predetermined number of shares of the companys common stock. The number of shares given to investors is determined by the conversion ratio. For example, a conversion of 50 to 1 means that investors can convert one bond with a $1,000 face value to 50 shares of common stock
Pros and Cons of Convertibles
The combination of bond and stock attributes makes convertible securities beneficial for investors. An advantage of investing in convertible securities is if the companys stock price is undervalued, you can earn a significant rate of return. Investors benefit from convertible bonds because the bond pays a fixed rate of interest until it is converted. This is especially beneficial if the company does not pay a dividend. A disadvantage of investing in convertible securities for some investors is the need to understand the bond and equity markets. Convertible bonds are tied to the issuing companys credit rating and typically pay less interest than regular corporate bonds. A disadvantage of investing in convertible bonds is that companies with poor credit ratings have a greater risk of defaulting.
Conversion Premium The amount by which the price of a convertible security exceeds the current market value of the common stock into which it may be converted. A conversion premium is expressed as a dollar amount and represents the difference between the price of the convertible and the greater of the conversion or straight- bond value. Convertibles are securities, such as bonds and preferred shares, that can be exchanged for a specified number of another form (typically common stock) at an agreed-upon price. Convertibles can be converted at the will of the investor or the issuing company can force the conversion.
Conversion Premium
The equity value of a convertible bond was determined to be its conversion value. Conversion premium can be calculated easily by simply taking the difference between the current market price of the convertible and the conversion value and expressing it as a percentage. Since the convertible bond is more secure than common stock and generally pays higher interest than the stock dividend, the convertible bond buyer is willing to pay a premium over conversion value. Market forces determine the amount of premium that a particular convertible may command in the marketplace. However, it should make sense that, as a convertible bond price increases above its investment value, its fixed income attributes give way to equity characteristics, decreasing the conversion premium. On the other hand, if the stock price declines, the convertible bond price approaches its fixed income value and the conversion premium increases. Convertible bonds that are trading near their fixed income values with substantial conversion premiums are called "busted converts." Their equity component is of little value, and they trade mainly on their fixed income characteristics.
Figure(next slide) depicts a typical convertible price curve, with the shaded area denoting conversion premium. Notice that as the stock increases in value, conversion premium gradually decreases until it becomes zero. At that point, the convertible market price and conversion value are equal. As the common stock declines in value, the convertible gains conversion premium because it is approaching its investment value. Conversion premium
Convertible Bonds: An Example
To help clarify some of these concepts, we present a hypothetical example in the table below and graphically. Assume that a new issue convertible has come to market. It has a 5 percent coupon and 10 years to maturity. The issuing company has other 10 year debt that carries an 8 percent yield, and the company's stock is currently trading at $42.
Convertible Bonds: An Example
XYZ Company
Convertible Bond
Coupon 5% Maturity 10 years Straight bond yield to maturity 8% Conversion price $50/share Current stock price $42/share Conversion ratio 20 shares per bond
Convertible Bond
Conversion premium & Investment Premium The bond indenture specifies a conversion price of $50. Since we know that the conversion price is the effective price for conversion into stock with the bond at par, we divide the par value of the bond ($1,000) by $50, resulting in a conversion ratio of 20 shares. To calculate the current conversion value, we know that the stock price is currently $42. Multiplying $42 by 20 shares, we get a current conversion value of $840. If the issue is sold at par, then the conversion premium would be 19 percent ([$1,000 - 840]/840). The investment value of the convertible at issuance would be the security with the 5 percent coupon discounted at a yield to maturity of 8 percent. The result, according to standard bond calculations, is 79.87, or a dollar value of $798.70. The investment premium would be 25.20 percent ([$1,000 - 798]/798).
A Convertible's Investment Value Investment Value Calculation =50 Annuity factor(8%,10years)+1000 PVIF(8%,10 years) =50(6.710)+1000(0.463) = 335.50+463.00=798.50
Investment Premium
The convertible bond's investment premium is the difference between the convertible's market price and its investment value, expressed as a percentage. An important measure of the basic value of the convertible is its premium over investment value. This value is important because it indicates the level of downside risk and can be monitored as market prices change. For example, in the case of a bond with a par value of $1,000 and an investment value of $798.70, the investment premium is ([1,000 - 798.70]/ 798.70), or 25.2 percent.
The higher the investment premium, the more sensitive the market price of the convertible is to a decline in the underlying common stock. A high market price relative to investment value is caused by increases in the value of the underlying stock such that the convertible's market value depends on the value of the stock. There is less downside protection because the stock would have to decrease in value by a significant amount before the market price of the convertible would approach the investment value and offer protection.
Similarly, when the investment premium is small, a small decrease in the value of the underlying stock would result in the market price reaching the investment value. At that time, the investment value floor serves as significant downside protection. Furthermore, when the investment premium is small, the convertible is more interest rate sensitive rather than equity sensitive and will typically be vulnerable to changes in market interest rates.
Basic convertible bonds calculations
stock price $30.00 per share stock dividend $0.50 per share convertible market price $1,000 coupon rate 7.00% maturity 20 years conversion price $36.37 Stock dividend yield = annual dividend rate/ current stock price= $0.50 / $30.00 = 1.67%
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
Premium for call right
An investor who purchases a convertible bond rather than the underlying stock typically pays a premium over the current market price of the stock. Why would someone be willing to pay a premium to buy this stock? The market conversion premium per share is related to the price of a call option limit the downside risk of the convertible bond. Conversion Premium Calculation Conversion premium = (convertible price conversion value) / conversion value = ($1,000 $825.00) / $825.00 = 21.21% Conversion premium In a bullish environment, the enthusiasm of the market boosts conversion premium levels. National Semiconductor Corporation (Sept 1995) coupon rate 6.5 percent and conversion premium of 45 percent. 3Com Corporation (Nov., 1994) coupon rate 10.25 percent and conversion premium of 70 percent. Bondholders are compensated with a high coupon rate while they wait for the stock price to rise.
Stock performance Embedded strike price Common dividend yield and dividend growth rate Stock volatility Life of warrant / call protection Floor value The floor value of a convertible bond is the greater of 1. Conversion value 2. Bond investment value value as a corporate bond without the conversion option (based on the convertible bonds cash flow if not converted). To estimate the bond investment value, one has to determine the required yield on a non-convertible bond with the same quality rating and similar investment characteristics. If the convertible bond does not sell for the greater of these two values, arbitrage profits could be realized.
Bond investment value
Present value of the interest and principal payments discounted at the straight (non-convertible) bond interest rate bond interest value = where P = par value, r = discount rate, C = coupon rate, n = number of periods to maturity. take r = 10% present present value value Years payment factor 1 - 20 $80 8.514 $681.12 20 $1,000 0.149 $149.00 $830.12
Estimation of the discount rate
Use the yield-to-maturity of a similar nonconvertible bond as a proxy. Ratings are not very responsive to changing financial fundamentals. The apparent deterioration of the creditworthiness of an issue will not be reflected in the convertible price because the common stock may be rising due to higher share price volatility.