Convertible Securities

Learning GoalsUnderstand the characteristics of convertible

securitiesHow to value convertible securities.

IntroductionFixed-income security that allows holder to

convert the security into a specified number of shares of the issuing company’s common stock

Two major types of convertible securities:Convertible bondsConvertible preferred stock

“Equity kicker”: another name for the conversion feature that allows holder to convert the security into a specified number of shares of common stock

Forced conversion: calling in of convertible bonds by the issuing firm

Conversion privilege: the conditions and specific nature of the conversion feature on convertible securities

Conversion period: the time period during which a convertible issue can be converted

Conversion ratio: the number of shares of common stock into which a convertible issue can be converted

Conversion price: the stated price per share at which common stock will be delivered to the investor in exchange for a convertible issue

Valuation on Convertible SecuritiesWhen the market price of the common stock

is greater than or equal to the conversion price, the convertible derives its value from the common stock.

When the market price of the common stock is below the conversion price, the convertible takes its value as a bond

Due to the equity kicker, convertibles are not as interest sensitive as straight bonds.

In theory, the market price of a convertible bond should never drop below its intrinsic value. The intrinsic value is simply the number of shares being converted at par value times the current market price of common shares.

Bond behaviourIn-the-money : Conversion Price is < Share PriceAt-the-money : Conversion Price is = Share PriceOut-the-money : Conversion Price is > Share Price

Conversion RatioConversion ratio is the number of shares of common

stocks received in exchange for convertible bonds.

Conversion ratio = Par ValueConversion price

  Ex: Par Value is RM 1,000 and conversion price is RM25 and the market price of the stock is RM 24 while the current price of the convertible bond is RM 880

Conversion ratio = RM 1,000/RM 25 = 40 shares.

Conversion ValueConversion Value: indication of what a

convertible issue would trade for if it were priced to sell on the basis of its stock value.

Conversion Value = Con. Ratio x Current market price of the stock

From the example:conversion value = 40 shares x RM 24

= RM 960

Conversion EquivalentConversion Equivalent: the price at which the common

stock would have to sell in order to make the convertible security worth its present market price

Conversion equivalent = Current m/price of convertible bond

(Conversion parity) Conversion ratio 

 From the above example:

Conversion equivalent = RM880 = RM22 per share

40

Conversion PremiumConversion Premium: amount above the

conversion value that investors are willing to pay; typically due to the higher current income provided by convertibles over common stock

if the convertible bond is given the market priceConversion premium = current market price -

conversion value of convertible bond

if the market price of the convertible bond is not given

Conversion premium= Par Value - conversion value

Conversion premium = Conversion price -market price per share common stock

Conversion premium (%) = Conversion premium ($)

Conversion Value

Payback PeriodPayback Period: the length of time it takes

for the buyer of a convertible to recover the conversion premium from the extra current income earned on the convertible

Payback period = Conversion premium (in RM)______ Annual interest Annual

dividend Income from the - income from the Convertible bond underlying c/stock

Benefit For InvestorsConvertible bonds are usually issued offering

a higher yield than obtainable on the shares into which the bonds convert.

Convertible bonds are safer than preferred or common shares for the investor.

The purchase of convertible bonds and the short sale of the same issuer's common stock is a hedge fund strategy known as convertible arbitrage.

Benefit For IssuersLower fixed-rate borrowing costsLocking into low fixed–rate long-term

borrowingHigher conversion price than a rights

issue strike priceVoting dilution deferredIncreasing the total level of debt gearing. Takeover paperTax advantages

Advantages of Convertible SecuritiesConvertible securities can reduce downside risk, Good upside potential because convertible bond must

always be worth at least conversion as the price of common stock rise

Current income are greater than dividends on common stock.

Investing in convertible securities allows the convertible securities holder to convert his/her bond/preferred stock into common stock, thus it enables the bondholder to become stockholder.

Convertible securities has unique combination of income stream from fixed-income security and chance to participate in the price appreciation of Common stock.

Compared to common stock owners, convertible bond holders enjoy a yield advantages while waiting for appreciation in the stock price.

Disadvantages of Convertible SecuritiesInvestors may have to give up some potential

profits in the event of forced conversionInterest rates are usually lower than the

ordinary bondsthere is a possibility that the market price of

the common stock did not go beyond the conversion price, thus making conversion unattractive to investors. When this happens they may lose out on the opportunity for capital gain.