Convertible Securities and Innovation

Overview• A convertible security is a type of equity offering,

even though most convertibles are originally issued in the form of a bond or preferred shares

• Most convertible bonds or convertible preferred shares are convertible anytime (after a three month period following issuance), at the option of the investor, into a predetermined number of common shares of the issuer

• This is called an “optionally converting convertible”• The other type of a convertible is a “mandatorily

converting convertible”, where the investor must receive a variable number of common shares (based on a floating conversion price) at maturity (a mandatory receipt rather than an option to receive)

Overview (cont.) The issuer’s preference regarding equity content of the

convertible determines whether the convertible will be issued as an optionally converting convertible or a mandatorily converting convertible

From the perspective of a credit rating agency, an optionally converting bond is considered to have bond-type characteristics since there is no assurance that the bond will convert into common shares and there is a fixed coupon payment obligation

As a result, when originally issued, an optionally converting bond weakens a company’s balance sheet in almost the same way that a straight bond of the same size and maturity would (although the company’s balance sheet will subsequently be strengthened if the convertible bond eventually converts into common shares)

Overview (cont.)By contrast, mandatorily converting

convertibles (mandatory convertible), from a credit rating agency perspective, are considered to have equity-type characteristics

This is because there is certainty regarding conversion into common stock (and therefore no cash repayment obligation at maturity in the event of non-conversion)

Therefore, mandatory convertibles strengthen a company’s balance sheet in almost the same way that a common share offering of the same size would

Rational for Issuing a Convertible• If a company wants to issue debt, they might

consider a convertible bond rather than a straight bond in order to reduce the coupon associated with debt issuance

• For example, if a company could issue a $100 million bond with a seven-year maturity and a coupon of 6%, that same company might be able to issue a convertible bond for the same amount and maturity, but with a coupon of 3%

• The reason convertible bond investors might accept a coupon that is 3% lower than a straight bond coupon is because the convertible bond gives them the option to receive a predetermined number of common shares of the issuer’s stock in lieu of receiving cash repayment

Rationale (cont.)• If the value of the common shares that

convertible bond investors have the right to receive does not exceed $100 million during the life of the convertible, they will generally not elect to convert the bond into shares and will therefore receive $100 million in cash at maturity in seven years

• If the value of the shares exceeds $100 million on or anytime before maturity, investors may elect to convert the bond and receive shares

Convertible Bond Component Parts

Convertible Bond Component Parts

-4%-3%-2%-1%0%1%2%3%4%5%6%7%

20 22 24 26 28

-4%-3%-2%-1%0%1%2%3%4%5%6%7%

20 22 24 26 28

-4%-3%-2%-1%0%1%2%3%4%5%6%7%

20 22 24 26 28

Bond with 6% couponCall option on $20 stock with $24Call strike price

Convertible=+

Breakeven price

Future share price

Econ

omic

Valu

e

Convertible Bond Example• A company issues a $100 million convertible with a seven-year

maturity and a 3% annual coupon. Investors are given the right to receive either $100 million repayment at maturity or, at their option, give up receipt of this cash amount in exchange for receiving a predetermined number of shares of the issuer’s common stock

• On the date of convertible issuance, the company’s stock price is trading at $25, and the company agrees to a “conversion price” for the convertible of $31.25, which is 25% above $25. This percentage is called the “conversion premium,” because the conversion price is set at a premium (in this case, a 25% premium) to the company’s share price on the date of convertible issuance

• The conversion price determines the number of shares that the investor has the right to convert into. This determination is made by dividing the total proceeds of the offering by the conversion price

• The result, in this example, is $100 million / $31.25 = 3.2 million shares

Convertible Example (cont.)Convertible investors, therefore, have a choice to

make: either take $100 million in cash at maturity or give up the cash right in exchange for receiving 3.2 million shares anytime at or before maturity

If, for example, the issuer’s share price increases to $45 at maturity in seven years, convertible investors might elect to give up the right to receive $100 million in cash in exchange for 3.2 million shares because the value of these shares would be 3.2 million x $45 = $144 million

In practice, most investors wait until maturity to make the conversion decision due to the value of the options embedded in the convertible, but they have the right to convert earlier.

Zero Coupon Convertibles A Zero Coupon Convertible (ZCC) is similar to a coupon-paying

convertible except, instead of paying interest coupons each year, the issuer increases the principal amount of the convertible by an amount equal to the unpaid coupon, creating an “accretion” of the bond

Although there are approximately the same number of underlying shares for a ZCC and a coupon-paying convertible, and ZCCs’ unpaid coupons are “paid” by increasing the principal amount of the convertible, a ZCC offers additional benefits

An issuer is able to receive tax deductions in relation to the annual accretion of the convertible, creating a positive cash flow bond financing (no cash payments for coupons, but tax deductions equal to the deductions the issuer would receive if a coupon paying convertible had been issued)

Also, there is a lower probability of conversion on the portion of the convertible that is not purchased by hedge funds because an unhedged investor will usually (assuming no credit or illiquidity concerns) only convert into common shares if the value of those shares exceeds the principal cash redemption value of the bond’s accreting principal amount, which increases each year

Mandatory Convertibles Unlike an optionally converting convertible where the investor

has the right, but not the obligation, to convert their bond holding into a predetermined number of the issuer’s common shares, a mandatory convertible requires conversion

Because an investor does not hold the right to demand cash repayment in the future (shares will always be delivered instead), credit rating agencies consider this security to be similar to equity

Because of this, a company seeking to issue equity may consider a mandatory convertible as an alternative to a common share issuance

Issuing a mandatory convertible has the benefit of receiving almost the same equity content from rating agencies as from a common share issuance, but with fewer shares delivered to investors if the company’s share price is higher on the maturity date (which is usually three years following issuance)

Mandatory Convertibles (cont.) A mandatory convertible has, in effect, a floating conversion price

that changes based on the company’s share price at maturity. The formula for determining the shares delivered at maturity is as follows If, at maturity, the issuing company’s share price (Maturity Price)

is at or below the share price on the convertible issuance date (Issuance Price), the shares delivered to investors will be identical to the shares that would have been delivered if common shares had been issued instead of the convertible (Shares Issued

If, at maturity, the company’s share price has risen but is less than the conversion price (usually set at 20-30% above the share price on the issuance date), the number of shares delivered to investors is equal to: Shares Issued x Issuance Price / Maturity Price

If, at maturity, the company’s share price exceeds the conversion price, the number of shares delivered to investors is equal to: Shares Issued x Issuance Price / conversion price

Mandatory Convertibles (cont.) If ABC Co decides to raise the funds through a $100 million mandatory

convertible that has a conversion price of $31.25 (25% conversion premium) when its common stock price is $25, ABC will be obligated to deliver 3.2 million shares at maturity if its share price equals or exceeds the conversion price at maturity ($100 million / $31.25 = 3.2 million shares)

If the company had decided to issue common shares when the stock was at $25 per share instead of a mandatory convertible, it would have had to sell 4 million shares to raise $100 million

Assuming ABC’s share price at the maturity of the mandatory is equal to or higher than the conversion price, the common share issuance would have resulted in the delivery of 25% more shares compared to a mandatory convertible offering of the same issuance size

If, however, ABC’s share price is $25 or lower at maturity of the mandatory convertible, the company will deliver 4 million shares, which is the same number of shares that would have been issued in a common share offering

Mandatory Convertible: Non-Unit Structure

Non-Unit Mandatory Convertible

Issuer Investors

Preferred stock

$100 million

Quarterly dividends

Preferred stock

Variable number of shares

Solid lines are initial cash flows and periodic payments

Dotted lines represent exchange of Preferred Stock for Common Stock at maturity in three years

Mandatory Convertible: Unit Structure

Marshall and Ilsley: Unit Mandatory Convertible

Source: McDonald, Robert L. Derivatives Markets. Prentice Hall, 2006. Auction added by David Stowell.

M&I InvestorsA

InvestorsB

Trust Stake

3.9% Interest

$25

Trust

Stock Purchase Contract

Trust as collateral for future stock purchase

Trust Stake

3.9% Interest

$25

30-year Subordinated Debt

3.9% Interest

$25

2.6% Dividend

$25

Variable number of common shares

2.6% Dividend

$25

Variable number of common shares

Solid lines are initial cash flows and periodic payments Dotted lines are cash flows at maturity of the Stock Purchase Contract in three years and cash flows at the time

of the auction to resell the trust stake in three years

Delta Hedging• The principal investors in most convertible securities are

hedge funds that engage in convertible arbitrage strategies

• These investors typically purchase the convertible and simultaneously sell short a certain number of the issuer’s common shares that underlie the convertible

• The number of shares they sell short as a percent of the shares underlying the convertible is approximately equal to the risk-neutral probability at that point in time (as determined by a convertible pricing model that uses binomial option pricing as its foundation) that the investor will eventually convert the security into common shares

• This probability is then applied to the number of common shares the convertible security could convert into to determine the number of shares the hedge fund investor should sell short (the “hedge ratio”)

Delta Hedging (cont.)• As an example, assume a company’s share price is $10 at the

time of its convertible issuance. A hedge fund purchases a portion of the convertible, which gives the right to convert into 100 common shares of the issuer

• If the hedge ratio is 65%, the hedge fund may sell short 65 shares of the issuer’s stock on the same date as the convertible purchase

• During the life span of the convertible, the hedge fund investor may sell more shares short or buy shares, based on the changing hedge ratio

• To illustrate, if one month after purchasing the convertible (and establishing a 65-share short position) the issuer’s share price decreases to $9, the hedge ratio may drop from 65% to 60%

• To align the hedge ratio with the shares sold short as a percent of shares the investor has the right to convert the security into, the hedge fund investor will need to buy five shares in the open market from other shareholders and deliver those shares to the parties who had lent the shares originally

Delta Hedging (cont.)• “Covering” five shares of their short position leaves

the hedge fund with a new short position of 60 shares• If the issuer’s share price two months after issuance

increases to $11, the hedge ratio may increase to 70%

• In this case, the hedge fund investor may want to be short 70 shares

• The investor achieves this position by borrowing 10 more shares and selling them short, which increases the short position from 60 shares to 70 shares

• This process of buying low and selling high continues until the convertible either converts or matures

Delta Hedging (cont.)• This dynamic trading process is called “delta

hedging”, which is a well-known and consistently practiced strategy by hedge funds

• Since hedge funds typically purchase between 60% and 80% of most convertible securities in the public markets, a significant amount of trading in the issuer’s stock takes place throughout the life of a convertible security

• The purpose of all this trading in the convertible issuer’s common stock is to hedge share price risk embedded in the convertible and create trading profits that offset the opportunity cost of purchasing a convertible that has a coupon that is substantially lower than a straight bond from the same issuer with the same maturity

Components of Convertible Arbitrage• There are three different sources of returns for

convertible arbitragers• (1) Monetizing Volatility– The mechanics of this are described above in the

delta hedging discussion– Whenever the underlying share price increases,

the value of the convertible holding increases slightly more than the loss from the short position, creating trading profits

– Whenever the underlying share price decreases, the value of the short position increases slightly more than the loss from the convertible holding, creating trading profits

Components of Convertible Arbitrage (cont.)• (2) Income Generation– The convertible investor generally receives a

coupon payment– Additional income comes from the interest

received from investing the cash proceeds from the short sale of underlying shares

– This income is reduced by payments the convertible investor must make to the stock lender:• Payments equal to dividends that the stock lender

would have received if shares had not been loaned out

• A fee for borrowing the shares, which is called rebate

Components of Convertible Arbitrage (cont.)• (3) Purchasing Undervalued Convertibles– Convertibles are generally sold at par (100% of

face value)– The theoretical value for most convertibles (based

on a binomial option based model that is used for convertible pricing) is usually 102%-107%

• These three components usually create total annual returns of 6-10%

• If the convertible investment is leveraged, total annual returns could fall in the range of 10-18%

• However, returns can be much less if all risks are not properly hedged

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problems is the essence of investment bankingCreativity and profit orientation must be combined

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Goldman Sachs has new product committees and an effective reward system for producers

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Nikkei Put Warrants

Nikkei Put Warrants

Nikkei Put Warrants

Nikkei Put Warrants

Accelerated Share Repurchase Program (ASR)• An ASR program is designed to capture the EPS benefit of a

repurchase program up-front, rather than waiting for the benefit to be realized over time

• This is accomplished by a contract under which a company purchases a large block of its shares from an investment bank at the closing market price on the date of the purchase, with a cash adjustment to follow at the end of the contract (which might be, for example, one year later)

• The investment bank borrows the shares it sells to the company from existing shareholders, creating a short position, which it covers through daily open market purchases that are limited to 25% of the company’s ADTV

• Assuming it takes one year for the investment bank to purchase enough shares to cover its short position, the total cost for the purchases of shares over this period is determined at the end of the year

ASR• If the total purchase cost is higher than the payment

received by the investment bank from the short sale of shares to the company one year earlier, the company reimburses the investment bank for the difference

• If the total purchase cost for the investment bank is less than the payment they received one year earlier, the investment bank reimburses the difference to the company

• This adjustment amount after one year is modified based on the returns that the investment bank achieves from investing cash they received from the company up-front (factoring in a reducing cash position each day as cash is used to purchase shares over the one-year period)

• A further modification to the cash adjustment is made to compensate the bank for their service

ASR

ASR