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Mandatory convertible securities

Product nature

• Mandatory convertible into common stock at maturity.

• They are effectively yield-enhanced common stock, andoffer no downside protection to the investor apart fromtheir higher yield. Holders of mandatory convertibles have voting rights.

• MCS have grown to constitute about 14% of the total USconvertible market.

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Mandatory convertible securities (cont’d)

• Issue price (lower strike price): the same as the common stock price at the time of issue.

• Conversion price – upper strike price: this is the price at which the MCS are convertible into common stock at a premium to the issue price.

• The conversion ratio at maturity changes depending on the price of the stock.

• At issue, the MCS is priced with a so-called conversion premium,which determines the level of the strike price for the long call inthe call spread (the upper strike).

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An MCS consists of the following pieces

MCS = Underlying common stock (stock price × lower conversion ratio)

+ (Out-of-the-money call option on the underlying common stock struck at the upper strike price) × upper conversion ratio

− At-the-money call option on the underlyingcommon stock struck at the lower conversionratio

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Perspective of the investor

• MCS involves shorting one unit of call with a lower strike price and long less than one unit of call with a higher strike price.

• Without the traditional downside support of investment value of a normal convertible.

• In return, the investor receives a higher dividend.

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Numerical example

Stock price at issue $27.875Upper strike $30.750Lower strike $25.000

ValuationLong stock value $27.875Long 0.8130 calls struck at $30.750 $5.411Short 1 call struck at $25 -$9.228Present value of net cash flow(from the higher dividend) +$4.391

_______Fair value $28.450

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Performance based conversion premium1. If the stock goes up from the issue price, the participation is

at first delayed until the point of the upper strike, and then rises at a reduced rate equal to the upper conversion number.

2. On the downside, participation is one-for-one with the stock.

Why it is called performance based premium?

The investor does not actually pay the conversion premium up front. The declining ratio represents the conversion premium paid by the investor – paid only when the stock performs well.

Both issuer’s and investors’ interests are aligned.

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Parallel debt MCSThe higher dividend paid by the issuer is not tax deductible. To get around the problem: pairing of the equity MCS with a debt security.

• All the proceeds from the sale of the MCS are invested in US Treasuries with maturities same as that of the MCS.

• The yield from the Treasuries is supplemented with an additional fee from the issuer to arrive at the stated yield on the MCS.

Parallel debt• The issuer enters the public debt market to issue an interest

bearing note with a maturity and face amount similar to the terms of MCS.

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Parallel debt MCS (cont’d)

• At maturity, the investor delivers either cash (the settlement fee) or the maturing Treasury note to satisfy the terms of the purchase contract of the MCS. Note that the same amount of cash will be paid but the number of shares may differ, depending on the share price at maturity.

• In return, at maturity, the issuer can use these proceeds to retire the corporate debt obligation.

• The Treasuries are owned by the investor – so the investor does not need to bear the default risk of the issuer.

• The investor also enjoys a tax benefit from this structure since that portion of the income received from the Treasury coupon payments is exempt from state and local taxes.

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PERCS- preferred equity redemption cumulative stock

• Offer investors a higher yield than the common stock and participate in price increases for the stock up to a cap price.

• PERCS can be called at any time, but the call price is usually at a premium to the cap price. The purpose of the call is to terminate prematurely the higher yield paid.

• Subject to mandatory redemption by certain maturity date.

• Payable either in cash or shares of the underlying stock.

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RJR Nabisco Holdings 9.25% (high value)due 1997 (PERCS)

Risk/Reward Table Time % change

in stock price

PERCS % change in

value

PERCS equity

participa-tion

Downside 1.00 year -27.1 -13.2 49%

0.5 year -20.0 -10.0 50%

0.5 year 25.0 18.5 74%

Upside 1.00 year 37.1 19.2 52%

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Convertible preferred stock• The holder has the right to convert to a specified number of

shares of the underlying common stock at any time.• It has a specified dividend rate that is declared by the board

of directors, usually quarterly. Preferred shareholders take precedence over common shareholders for dividend payments.

• There is no maturity date, unlike the convertible bond.• After the call protection expires, the company has the

option of redeeming the issue at the stated par value or call price.

• Exchangeable feature: gives the company the additional option of exchanging the convertible preferred stock for convertible bonds.

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Exchangeability: Into MSFT 2.75% Convertible Notes due 1999 beginning 3/15/97 on any dividend date. Terms essentially are identical to MSFT 2.75% Cvt. Pfd. except for certain maturity settlement features (see below).

Maturity Settlement (bond): Differs from MSFT 2.75% Cvt Pfd. in three respects:

1. Investors must elect conversion option or else the bond will be automatically redeemed for $79.875.

2. Investors receive an additional $0.40/share if they elect to convertat maturity.

3. If settled in stock, investors get the number of shares equal to 99.5% of the maturity settlement value.

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Summary Term Sheet/Structure - Microsoft 2.75% Convertible Exchangeable Preferred

Principal protection at par: $79.875 par Dividend: 2.75%Dividend Settlement: Cash Conversion Prices: High Strike = $102.24 ( Cap

Price). Low Strike = $79.875 (Floor Price).

Conversion Premium: 28.0% ($102.24 Cap Price vs. $79.875 common price at issuance)

Credit Rating: A1/AA-Issue Size: $1.0 Billion (12,519,562

shares)

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Convertibility: Not before maturity (European style option)

Hard Call: Non call life = 3.0 years (12/15/1999)Maturity: 12/15/1999Maturity Settlement: Paid in stock and/or cash based on

20-trading day MSFT average close ending 2-trading days prior to maturity date.

1. If $79.875 <= MSFT <= $102.24, investor gets 1.0 share of MSFT or the cash equivalent.

2. If MSFT<= $79.875, investor gets the number of MSFT shares equivalent to $79.875 or the cash equivalent.

3. If MSFT >= $102.24, investor gets the number of MSFT shares equivalent in value to $102.24 or the cash equivalent.

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Valuation of MSFT 2.5% Convertible Exchangeable Preferred

• At maturityThe annualized minimum return on investment would be

2.75 percent if, in three years, the stock were worth $79.875 orless. The maximum annualized return on investment over three years would be 11.4 percent if the stock were $102.24 or greater.

• Within the life of the instrument, the equivalent synthetic is 1. Long common stock at 79.875.2. Long put on common stock at a strike price of 79.875,

expiration on December 15, 1999.3. Short call option with a strike of 102.24, expiration on

December 15, 1999.4. Yield advantage over common stock 2.75 percent.

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Equity-linked securities (ELKS)In August 1994, Solomon Brothers issued an ELKS linked to the performance of Digital Equipment Corporation.

• In return for accepting the limitation on upside potential, the investor receives a yield premium of 6.75 percent over the common stock.

• At maturity, the value is settled in cash rather than through conversion to the common stock.

Analogy to the covered call strategiesOwner of a certain stock sells out-of-the-money call options against the stock to collect an upfront premium – here in the form of higher yield.

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Debt Exchangeable for Common stock, DECS

American Express used DECS to convert book assets to cash on its stake in First Data Corp (stock of another company)• AE sold its stake at a conversion premium of 22 percent to

the current market price and yet also deferred the capital gain.

• At the end of Year Three, investors receive 0.819 of common stock if share price > $44.875 one share of common stock if otherwise.

The upside potential is 81.9 percent of the upside above conversion price.

• Upon redemption, issuer can choose to redeem in stock or cash.

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DECS (cont’d)

Summary• Investor participate 1:1 below the cap price but forego any

capital appreciation until the conversion price has been attained and then receive 80-90% of the upside.

• The security is issued with voting rights, and most have 3-year call protection. After 3 years, the company can call the issue at pre-specified premiums to the issue price plus accrued dividends.

• Conversion is mandatory, payable in cash or shares of common stock, at issuer’s option. This gives the flexibility to the issuer in terms of equity / cash balance.

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DECS (cont’d)

Equivalent synthetic position

• Long common stock.• Long an out-of-the-money call option with a

strike at the conversion price times the conversion ratio.

• Short an at-the-money call option on the stock.• Present value of income advantage over common

stock dividend.

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Convertible monthly income preferred stock

Similar to convertible preferred , MIPS are issued by a special-purpose entity, called a special purpose subsidiary(SPS) set up by the parent company.

• The SPS lends the proceed of the stock to its corporate parent. The corporate parent can deduct the interest payments on the debt.

• MIPS dividends are paid monthly, rather than semi-annually.

• MIPS are viewed as equities by the rating agencies, and the issuer reduces the level of debt carried on its balancesheet and gains additional flexibility in its financing needs.

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Convertible MIPS (cont’d)

• Conversion to common stock is at option of the holder at any time prior to conversion expiration date.

• Redemption at par value at the issuer’s option and upon maturity.

1. The call terms are fixed at the time of issue.2. MIPS offer call protection, usually up to 5 years, and

mature in 30 years at par value with possible extensions.