Part 6 – Structured convertibles Mandatory convertibles (with parallel debts arrangement)

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1 t 6 – Structured convertibles ndatory convertibles (with parallel debts arrangeme lso called Premium Exchangeable Participating Secur changeables set-backed convertibles EDIT structure (credit enhanced debt indexed to sto nvertible stock notes nvertible preferred stocks uity-linked securities bt exchangeable for common stock

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Part 6 – Structured convertibles Mandatory convertibles (with parallel debts arrangement) (also called Premium Exchangeable Participating Securities) Exchangeables Asset-backed convertibles CrEDIT structure (credit enhanced debt indexed to stock) Convertible stock notes - PowerPoint PPT Presentation

Transcript of Part 6 – Structured convertibles Mandatory convertibles (with parallel debts arrangement)

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Part 6 – Structured convertibles

• Mandatory convertibles (with parallel debts arrangement) (also called Premium Exchangeable Participating Securities)• Exchangeables• Asset-backed convertibles• CrEDIT structure (credit enhanced debt indexed to stock)• Convertible stock notes• Convertible preferred stocks• Equity-linked securities• Debt exchangeable for common stock

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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.

-100% equity participation on the downside move of the share price- reduced (say, 80%) equity participation on the upside move

Appropriate for investors with a favorable view of the common stock and in need of high current income.

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Mandatory convertible securities (cont’d)

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

• Lower strike price: Usually, it is taken to be the same as the common stock price at the time of issue. When the stock price at maturity falls

below, the investor suffer 100% equity participation of the downsideloss.

• When the stock price at maturity shoots above the upper strike price,the investor starts to gain equity participation (reduced) of the upsidegrowth.

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Performance based conversion premium

1. 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.

The 0.2 share difference represents the premium earned by theissuer.

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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 the forward sale of equity at a price higher than the current stock price, but without the traditional downside support of investment value of

a normal convertible.

• In return, the investor receives a higher dividend.

• Less interest rate sensitive but more equity sensitive compared to convertibles. Changes in interest rates affect the value of the “excess” coupon stream. To a less extent, the value of the two embedded options.

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Sensitivity to volatility and gamma

• MCS consists of two call options, the long partial option is less expensive than the short option. Therefore, it is short volatility. This is in contrast to traditional convertible bonds, which are long volatility.

• Shorting gamma: holder participates in a portion of the upside, while sharing in all the downside of the underlying stock. The gamma profile is most dynamic at common price level between the lower and upper strike prices.

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Numerical example

Stock price at issue $20Upper strike $25Lower strike $20

ValuationLong stock value $20Long 0.8 calls struck at $25 $5.3Short 1 call struck at $20 -$8.2Present value of dividend cash flow +$4.2

_______Fair value $21.3

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Parallel debt MCS

The 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. He then receives the stocks, like usual MCS.

• 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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Exchangeable convertible bonds They are issued by one company and converted into the stock of another company. Example Pennzoil owned over 18,000,000 shares of Chevron common stock. Using this stock as collateral, Pennzoil issued over $902,000,000 worth of bonds convertible into Chevron shares. Advantages

Received the proceeds for selling the issues at a 21% premium over Chevron’s current stock price.

Pennzoil received $33.4 million annually in dividends from the Chevron shares. Disadvantages Forfeit the potential upside growth of the stock price. Continue to be exposed to the potential downside risk of the stock (no conversion made).

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Rationale for issuing exchangeables

The issuer wants to monetize the value of a non-strategic asset in a tax-efficient manner. This is an alternative form of capital raising. The shares in a third company may be helddue to aborted takeover.

The issuer receives the proceeds of the sale immediately (at a premium to the current share price and may gain advantage from higher volatility of share price prior to aborted takeover), but does not have to pay capital gains tax until the bonds are actually converted several years in the future.

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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.• 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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Asset-linked convertibles Combined the security of fixed income with convertibility into precious metal instead of common stock. Example Sunshine Mines issued a convertible bond with a 15-year maturity and an 8.5 percent coupon, convertible into silver at $20 an ounce.

The issuer is willing to share the potential price appreciation of the underlying commodity in exchange for a lower coupon rate and better terms in bond indentures.

Payouts can be in either the commodity or its cash equivalent.

Investors looked to metal to preserve their capital when inflation is pronounced.

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CrEDITS structure (Credit Enhanced Debt Indexed To Stock)

• Characteristic Principal and coupon payments are guaranteed by an irrevocable

letter of credit from a highly rated financial institution.

• Issuer’s perspective Pay a lower coupon rate. Get the credit guarantee by paying amount less than the coupon rate differential.

- Six percent coupon rate is reduced to four percent but with principal and income guaranteed by a high-rated third party. This works well if the protection requires less than the 2 percent coupon rate differential.

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CrEDITS structure (cont’d)

Attraction to investors

1. Upside potential of an emerging market or growth stock;

2. A name with high stock volatility;

3. High-quality downside protection that is uncorrelated to the shares.

All Taiwan dollar CB issuance must be guaranteed by a financial institution. A lot of the issuance is fairly weak in credit.

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Convertible stock notes

• Instead of paying interest and principal in cash, these notes pay in common stock or cash, at the issuer’s option (designed to give issuers flexibility in managing cash flow).

• They are typically issued by troubled companies. Companies facing bankruptcy often ask creditors to exchange debt for convertible stock notes (allowing for increased equity participation but forfeiting coupon incomes).

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ExampleAnacomp - facing bankruptcy in the mid-1980s• proposed to exchange the convertible 137/8 percent bonds for convertible stock notes with higher conversion ratio (increased to 250 shares per bond from 57.143).

As the stock price recovered to $8 (original conversion price was $17.50) in mid-1987, the new convertible stock notes had an intrinsic value of 200% of par.This illustrates the advantage of being a creditor rather than a shareholder when a company’s fortunes change.

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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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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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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 convert at 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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Valuation of MSFT 2.5% Convertible Exchangeable Preferred

• At maturity The annualized minimum return on investment would be 2.75 percent if, in three years, the stock were worth $79.875 or less. 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 Long common stock at 79.875. Long put on common stock at a strike price of 79.875, expiration December 15, 1999. Short call option with a strike of 102.24, expiration December 15, 1999.

Yield advantage over common stock 2.75 percent.