Convertibles, Warrants, and Derivatives
(Part A)
by
Charles Lamson
There are as many types of securities as there are innovative corporate treasurers or forward-looking portfolio managers. As we have discussed in the previous posts, corporate financial managers usually raise long-term capital by selling common stock, preferred stock, or bonds. Occasionally a company will issue convertible securities, which are a hybrid security combining the features of debt and common equity. Sometimes to sweeten a straight debt offering, the financial managers may attach warrants to a bond offering. Warrants are a type of derivative security because they derive their value from the underlying common stock price. Other derivative securities introduced in the next few posts are options and futures contracts.
The funds from convertible bond offerings are often used to pay off existing short-term debt coming due or to take advantage of low interest rates. Convertible securities offer the chief financial officer an alternative source of financing that combines the features of common stock and bonds, or common stock and preferred stock. Convertible Securities A convertible security is a bond or share of preferred stock that can be converted, at the option of the holder, into common stock. Thus the owner has a fixed income security that can be transferred into common stock if and when the affairs of the firm indicate such a conversion is desirable. Even though convertible securities are most often converted into common stock, some convertible preferred stock is exchangeable, in turn, into convertible bonds, which are then convertible into common stock. Additionally, when a company is merged with another company, sometimes the convertible securities of the acquired company may become convertible into common stock of the surviving company. While these departures from the norm are interesting, in the next few posts we focus on convertible bonds (debentures) that result in the potential for common stock ownership and recognize that the same principles apply to other forms of convertibles. When a convertible debenture is initially issued, a conversion ratio to common stock is specified. The ratio indicates the number of shares of common stock into which the debentures may be converted. Assume that in 2020 the Lamson Company issued $10 million of 25-year, 6 percent convertible debentures, with each $1,000 bond convertible into 20 shares of common stock. The conversion ratio of 20 may also be expressed in terms of a conversion price. To arrive at the conversion price, we divide the par value of the bond by the conversion ratio of 20. In the case of the Lamson Company, the conversion price is $50. Conversely the conversion ratio may also be found by dividing the par value by the conversion price ($1,000/$50 = 20). Value of the Convertible Bond As a first consideration in evaluating a convertible bond, we must examine the value of the conversion privilege. In the above case, we might assume that the common stock is selling at $45 per share, so the total conversion value is $900 ($45 * 20). Nevertheless, the bond may sell for par or face value ($1,000) in anticipation of future developments in the common stock and because interest payments are being received on the bonds. With the bond selling for $1,000 and a $900 conversion value, the bond would have a $100 conversion premium, representing the dollar difference between market value and the conversion value. The conversion premium generally will be influenced by the expectations of future performance of the common stock. If investors are optimistic about the prospects of the common stock, the premium may be large. If the price of common stock really takes off and goes to $60 per share, the conversion privilege becomes quite valuable. The bonds, which are convertible into 20 shares will go up to at least $1,200 and perhaps more. Note that you do not have to convert to common immediately, but may enjoy the price movements of the convertible in concert with the price of the common. What happens if the common stock goes in the opposite direction? Assume that instead of going from $45 to $60 the common stock drops from $45 to $25---what will happen to the value of the convertible debentures? We know the value of a convertible bond will go down in response to the drop in the common stock, but will it fall all the way to its conversion value of $500 (20 * $25 per share)? The answer is clearly no, because the debenture still has value as an interest-bearing security. If the going market rate of interest in straight debt issues of similar maturity (25 years) and quality is 8 percent, we would say the debenture has a pure bond value of $785.46. The pure bond value equals the value of a bond that has no conversion features but has the same risk as the convertible bond being evaluated. Thus a convertible bond has a floor value, but no upside limitation. The price pattern for the convertible bond is depicted in Figure 1. Figure 1  We see the effect on the convertible bond price as the common stock price, shown along the X-axis, is assumed to change. Note that the floor (pure bond) value for the convertible is well above the conversion value when the common stock price is very low. As the common stock price moves to higher levels, the convertible bond price moves together with the conversion value. Where the pure bond value equals the conversion value, we have the parity point (P). Is this Fool's Gold? Have we repealed the old risk-return trade-off principle? To get superior returns, we must take larger-than-normal risks. With convertible bonds, we appear to limit our risk while maximizing our return potential. Although there is some truth to this statement, there are many qualifications. For example, once convertible debentures begin going up in value, say $1,000 or $1,200, the downside protection becomes pretty meaningless. In the case of the Lamson Company in our earlier example in Figure 1, the floor is at $785.46. If an investor were to buy the convertible bond at $1,200, he or she would be exposed to $414.54 in potential losses (hardly adequate protection for a true risk averter). Also if interest rates in the market rise, the floor value, or pure bond value, could fall, creating more downside risk. A second drawback with convertible bonds is that the purchaser is invariably asked to accept below-market rates of interest on the debt instrument. The interest rate on convertibles is generally one-third below that for instruments in a similar risk class at time of issue. In the sophisticated environment of the bond and stock markets, one seldom gets an additional benefit without having to suffer a corresponding disadvantage. You will also recall that the purchaser of a convertible bond normally pays a premium over the conversion value. For example, if a $1,000 bond were convertible into 20 shares of common stock at $45 per share, a $100 conversion premium might be involved initially. If the same $1,000 were invested directly in a common stock at $45 per share, 22.2 shares could be purchased. In this case, if the shares go up in value, we have 2.2 more shares on which to garner a profit. Lastly convertibles may suffer from the attachment of a call provision giving the corporation the option of redeeming the bonds at a specified price above par ($1,000) in the future. In an upcoming post, we will see how the corporation can use this device to force the conversion of the bonds into common stock. None of these negatives is meant to detract from the fact that convertibles carry some inherently attractive features if they are purchased with appropriate objectives in mind. If the investor wants downside protection, he or she should search out convertible bonds trading below par, perhaps within 10 to 15 percent of the floor value. Though a fairly large move in the stock may be necessary to generate upside profit, the investor has the desired protection and some hope for capital appreciation. *MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 557-561* end |
No comments:
Post a Comment