Part 5 — Convertible bonds as an asset

Part 5 - Convertible bonds as an asset class • Various features in convertible bonds • Issuance of convertibles - perspectives of corporate treasurers - conversion into shares - call (hard and soft provisions) - put - reset on conversion number - dilution protection • Delayed call phenomena • Decomposition of convertibles into different components • Valuation of convertibles - interest rate sensitivities (duration analysis) - binomial tree calculations 1

Combination of bonds and equities - bond plus a conversion option * Bondholder has the right to convert the bond into common shares at some contractual price (conversion number may change over time). Conversion value: stock price x conversion number Conversion premium: (bond price – conversion value) / conversion value Bond floor value: sum of present value of coupon and par convertible bond price conversion premium conversion value straight bond value stock price 2

Perspectives on convertibles • To take advantage of the upside potential growth of the underlying stock (participation into equity). Conversion option that allows the investor to exchange the straight bond for fixed number of shares. • Swapping the variable stock dividends in return for fixed coupon payments until the earlier of the maturity date and the conversion date. • Provides the “bond floor” value as downside protection. 3

Analytics of convertible bonds stock price stock dividend convertible market price coupon rate maturity conversion price $30. 00 per share $0. 50 per share $1, 000 7. 00% 20 years $36. 37 Stock dividend yield = annual dividend rate / current stock price = $0. 50 / $30. 00 = 1. 67% 4

Conversion ratio = number of shares for which one bond may be exchanged = par / conversion price = $1, 000 / $36. 37 = 27. 50 shares Conversion value = equity value or stock value of the convertible = stock price x conversion ratio = $30. 00 x 27. 50 = $825. 00 5

Premium for conversion right • An investor who purchases a convertible bond rather than the underlying stock typically pays a premium over the current market price of the stock. • Why would someone be willing to pay a premium to buy this stock? The market conversion premium per share is related to the price of a call option – limit the downside risk of the convertible bond. 6

Conversion premium = (convertible price – conversion value) / conversion value = ($1, 000 – $825) / $825. 00 = 21. 21% Dollar premium = (convertible price – conversion value) /convertible price = ($1, 000 – $825) / $1, 000 x 100% = 17. 50 points 7

Capture of accrued interest upon conversion • Upon conversion to stock, any accrued interest will be lost. This is the infamous screw clause. • Trick - sell an equivalent amount of stock short against the convertible bond, hold the short sale until the interest payment date; then convert the bond and deliver the stock against the short sale. 8

Break even calculations Break even (years) = conversion premium / (convertible yield – stock yield) = 21. 21 / (7. 00 – 1. 67) = 3. 98 (years) Number of years necessary for the stock investor to recover the conversion premium from the convertible’s higher income relative to an instrument of an equivalent amount in the stock. After 3. 98 years, the convertible has made up, in income alone, the amount of the conversion premium. 9

Break-even calculations (cont’d) Dollar maintenance market price – conversion value = coupon - market price stock dividend stock price The time it takes for the convertible yield advantage to pay for its premium compared to an equivalent dollar amount purchased of the underlying stock. • May use conversion ratio instead of market price/ stock price. 10

Weaknesses of break-even analysis • It ignores the main advantage of convertible: protection on downside risk on the underlying equity. • It ignores the margin of safety offered by the convertible with the payment of principal at maturity. 11

Call terms Issuer has the right to call back the bond at a pre-specified call price prior to final maturity, usually with a notice period requirement. Upon call, the holder can either convert the bond or redeem at the call price. Issuer’s perspective on the call right • Refinancing To have the flexibility to call if they think they can refinance the debt more cheaply. • Managing the debt / equity balance To force bondholders to convert debt into equity, which can reduce debt levels. The issuer has the flexibility to shift debt into equity to reduce the leverage of the firm. 12

Call protection Hard (or absolute): To protect the bond from being called for a certain period of time. Soft (or provisional): The issuer is allowed to call only when certain conditions are satisfied. For example, the closing price of stock has been in excess of 150% of the conversion price on any 20 trading days within 30 consecutive days. Investor’s protection To preserve the value of the equity option for the bondholders. While waiting for the stock price to increase, convertibles typically provide more income than the stock. Without the call protection, this income stream could be called away at any time. Hard call protection with the longest possible duration is the most desirable for the investors. 13

Background for make-whole provision 1. Provisional call protection give issuers the option to retire the debt early, while the make-whole payment just what would have had to make anyway. 2. They are designed to protect investors from sharp premium contraction in a rapidly rising equity market. Make-whole payments should become a price variable at the point where a convertible without a make-whole provision, given a rising common stock, would begin to lose premium. 14

Make-whole provision Premium make-whole provision • First issuance of Amazon. com 4. 75% convertible note in January 1999 • Assures that holders will recover the amount of original premium paid at issuance, less any interest already paid. Soft (or provisional): The issuer is allowed to call only when certain conditions are satisfied. For example, the closing price of stock has been in excess of 150% of the conversion price on any 20 trading days within 30 consecutive days. 15

Put feature Allows the holder to sell back the bond to the issuer in return for a fixed sum. Usually, the put right lasts for a much shorter time period than the maturity date of the bond. • The holder is compensated for the lesser amount of coupons received in case the equity portion of the convertible has low value. • It protects the holder against rising interest rates by effectively reducing the year to maturity. The convertible’s price then becomes less sensitive to interest rate. The put feature may shorten the maturity of the bond (par paid earlier) and thus effectively raises its investment value and lower the sensitivity to interest rate fluctuation. 16

Reset feature in convertible bonds In most cases, the reset on conversion price is downward and this makes the bond more valuable. For example, the conversion number is reset by dividing the par by the prevailing stock price. Floor limit The extent of downward reset cannot be below a certain multiplier of the first conversion price. 17

Why reset convertible bonds are popular in Japan in mid 1990’s? • Japanese banks were considered quite risky as they had large real estates exposures. • To raise capital a. equity issuance was out of the question since the stock markets were depressed; b. straight bond issues would have required a high coupon yield. Reset feature was included in convertible bonds to give investors some sort of insurance against bank’s stock decline. 18

Pricing difficulties There are many possible conversion prices since they depend on the past history of the stock price. Impact on bond price At high stock price (not likely to reset) or low stock price (low equity value) regions, the reset premium is low. The reset premium is significant only at intermediate stock price level. Nightmare for the issuers The feature is too sweet for the investors and harmful to the issuer. • When the stock price drops, the investors are compensated. • When the stock price rises, the conversion premium becomes more expensive. These structures have fallen from popularity in recent years. 19

Takeover clauses An unexpected takeover bid can have the effect of eliminating any conversion premium if the takeover price is below the conversion price. Poison put is added as protection in the change-ofcontrol clause: triggered as a result of a hostile takeover and would allow the bondholder to put the bonds back to the company at par. Alternatively, the issuer can prevent the conversion premium from evaporating by increasing the conversion ratio to restore the premium to the average level seen before the takeover announcement. 20

Dilution protection (extraordinary dividends) Convertible investors are not compensated for normal dividend payment. However, if a company makes an extraordinary payment, resembling a return of capital, convertible holders want to be compensated. Dilution protection clause may be added: If the dividend payment yields more than a specified amount, any amount over the threshold will be compensated. 21

Convertible bond issued by the Bank of East Asia US$250, 000 2. 00 percent Convertible Bonds due 2003 Issue date July 19, 1996 Issue price 100 percent of the principal amount of the Bonds, plus accrued interest, if any, from July 19, 1996 (in denominations of US$1, 000 each) Conversion period From and including September 19, 1996 up to and including July 7, 2003 22

Conversion feature Conversion price HK$31. 40 per Share and with a fixed rate of exchange on conversion of HK$7. 7405 = US$1. 00. Dilution protection The Conversion Price will be subject to adjustment clause for, among other things, subdivision or consolidation of the Shares, bonus issues, right issues and other dilutive events. 23

Call feature Redemption at the option of the bondholders On or after July 19, 1998, the Issuer may redeem the Bonds at any time in whole or in part at the principal amount of each Bond, together with accrued interest, if for each of 30 consecutive Trading Days, the last of which Trading Days is not less than five nor more than 30 days prior to the day upon which the notice of redemption is first published, the closing price of the Shares as quoted on the Hong Kong Stock Exchange shall have at least 130 percent of the Conversion Price in effect on such Trading Day. 24

Soft call protection Parisian feature The closing price has to be above 130 percent of the conversion price on consecutive 30 trading days. • On the date of issuance of the notice of redemption (treated as day 0), the Issuer looks back 5 to 30 days (corresponds to [-30, -5] time interval) to check whether the history of the stock price path satisfies the Parisian constraint. That is, the last of the 30 trading days falls in [-30, -5] time interval. • From Issuer’s perspective, when the Parisian constraint has been satisfied, the Issuer has 5 to 30 days to make the decision on redemption or not. 25

Put feature Redemption at the option of the bondholders On July 19, 2001, the Bonds may be redeemed at the option of the Bondholders in US dollars at the redemption price equal to 127. 25 percent of the principal amount of the Bonds, together with accrued interest. The investors are protected to have 27. 25% returns on the bond investment upon early redemption by the issuer. 26

Put above par value or premium redemption at maturity Renong Berhad (a Malaysian company) issued a 5 -year bond with a 2. 5 percent coupon with yield-to-put at 7. 5 percent and a put price of 129. 7. This is above the par of 100 used in the calculation of conversion into stock. Also, this results in increased downside protection in case the equity portion has low value. Investors’ perspective Even if the conversion turns out to be unprofitable, they are guaranteed a 7. 5 percent return to the time of the put. 27

Examples of reset convertibles • United Artists Communications (1987) issued convertibles that after a fixed period of time, the bonds were evaluated by an independent investment banker. This is to determine the coupon rate that would allow the bonds to trade at 101 plus accrued interest. • Mitsuibishi Bank issued (Oct. , 1995) $2 billion of 7 -year bond with annual reset of the conversion ratio. It offers investors more shares if the stock price declines, with the goal of keeping the bond’s equity value at par. 28

Casino operator brings ringgit convertible • Malaysia's only casino operator, Resorts World, has raised M$1. 1 billion ($300 million) from a convertible bond that was well received despite offering a negative yield. • Desire to see bonds convert prompts Resorts World to use rare negative yield structure – less bond characteristics. • Reset feature added to prompt higher propensity of conversion. 29

Bond indenture • Negative yield Issuing the zero-coupon bonds at par and setting the redemption price at 99%, which results in a yield to maturity of -0. 5%. • Lower conversion price The conversion price was fixed at launch at 10% over yesterday's (September 7, 2006) volume weighted average price of M$11. 593, giving an initial conversion price of M$12. 75. 30

• Forced conversion There is an issuer call after one year, subject to a 120% hurdle, to force conversion in case investors drag their feet. • The reset mechanism has a floor at 90. 9% of the original conversion price, which is high compared with the typical reset floor at 80 -85%. • The bonds were priced assuming a credit spread of 40 basis points over the Malaysian interest rate curve, a dividend yield of 2. 2% or 120% of the previous year's, and a stock borrow cost of 5%. 31

Issuer’s perspectives • While common a few years back when interest rates were much lower, negative yields are rarely seen on CBs nowadays but highlights the issuer's desire to have the bonds convert in order to get equity on its balance sheet. • The bonds have a short maturity of only two years, a conversion premium of only 10% and two conversion price resets - after the first year and 60 days before maturity - making it all but inevitable that the bonds will convert. 32

Investor’s perspectives The bond floor was set at 90. 7%, which one observer says is "reasonably attractive" given the strong focus on conversion and the implied volatility is 24%. Market background • The share price is up a modest 4. 5% this year to Thursday's closing price of M$11. 70, which compares with a 6. 2% gain in the Kuala Lumpur Composite Index. • The expected appreciation of the ringgit makes the bonds a reasonable proposition. • Of the 19 analysts that cover the company, according Bloomberg data, 16 have a "buy" or "overweight“ recommendation. to 33

Types of companies as convertible issuers Companies that are characterized by strong performing, highvisibility, sub-investment grade, high-growth potential have comparative advantage in the convertible market versus the fixed income market. § They lack a long-term track record and have volatile capital structures – high coupon must be offered. § They can transform the high volatility into a benefit since the warrant is more expensive. § When the company grows, they may call the bonds. This in turn will strengthen the company’s equity base at the moment 34 when it is most needed.

Convertibles as backdoor equity financing Delayed equity Convertibles provide a way of selling common stock at a price above the existing market. They are employed as deferred common stock financing. The call feature is important since it gives the company the means to shift debt to equity. Convertibles offer a means to control the debt/equity ratio. 35

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Reasons for offering (cont’d) By order of importance, please rank the following factors on a scale of 1 to 6 on the extent to which it influenced your firm’s decision to issue convertible; 1 = most influential, 2 = next most influential, etc. ) 37

Environment in which issuance occurred 1. In retrospect, my firm’s stock was _____ valued around the time of the convertible debt offering. 2. Around the time of the convertible debt offering, my firm’s management expected future earning to be _____ the market was expecting. 3. At the time of the convertible debt offering, prospects for my firm’s short-term (1 -2 years) performance relative to its industry were: 38

Delayed call phenomena • Firms wait until the value of the bond value is much higher that the call price times the conversion number before issuing the call. In Ingersoll’s study of 179 convertibles, the percentage amount exceeded had a median of 43. 9%. • How to explain such delayed call phenomena? • Several possible theories are proposed for the rationales of delayed call. 39

Safety premium • Since convertible bond covenants typically require 30 -day notice before the bonds are redeemed, and during that period, the stock price may fall (likely to fall given the normal negative reaction to the call announcement), forcing the firm to redeem for cash. • There would be a higher cost to raise funds shortly so that the calling firms require a safety premium on the risk that the stock price may drop significantly over the notice period causing the bond to become out-of-the-money. 40

Tax advantage • Some firms enjoy an advantage of paying less in after-tax interest than they would pay in dividends were the bond converted. • Therefore, firms have the incentive to keep the bond alive even if the net present value of coupons to be paid somewhat exceeds the net present value of the dividends that would be paid to the former bondholder following conversion. 41

Stripping different components of convertible bonds A convertible bond consists of 3 components • bond component – interest rate risk • equity component – equity risk (long volatility) • credit quality component - credit risk Fixed income investor coupon payment principal Financial institution holding a convertible bond periodic payment contingent upon default Default risk protection provider 42

Contingent claims approach Wide spread use of the option pricing theory for pricing convertibles. § The underlying state variable is the issuer’s firm value process. The firm value is not the total value of assets owned by the firm. It is the takeover value when the firm is sold. § Overall assessment of the price impact of different features in a convertible. 43

Dominant factors in structural models for risky convertibles 1. 2. 3. 4. 5. 6. Issuer’s firm value process - volatility. Issuer’s capital structure – debt/equity ratio. Loss given default. Terms and conditions of the debt issue. Interest rate process. Correlation between the interest rate and asset value. • Difficult to estimate the parameter values when implementing the models. 44

Structural models for pricing convertible bonds Assumptions • Non-callable and can be converted only at maturity. • No transaction costs and no bankruptcy costs. • Capital structure consists of common shares and noncallable convertibles. 45

N = number of common shares M = number of convertibles f = face value per convertible F = face value of the convertible issue = Mf r = conversion ratio Upon conversion, the convertible holders will possess l fraction of equity, where The parameter l is called the dilution factor of the convertible issue. 46

Let VT denote the value of the firm at maturity after the last coupon has been paid. The holder will convert if and only if l VT > F Value of the convertible bond at maturity 47

payoff to convertible straight bond rrant wa F F/l Decomposition into a straight bond plus l units of call with strike F/l and short a put to issuer VT 48

Intrinsic value of convertibles The intrinsic value of a convertible bond is the greater of 1. Conversion value 2. Bond investment value – value as a corporate bond without the conversion option (based on the convertible bond’s cash flow if not converted). • To estimate the bond investment value, one has to determine the required yield on a non-convertible bond with the same quality rating and similar investment characteristics. • If the convertible bond does not sell for the greater of these two values, arbitrage profits could be realized. 49

Convertible = bond + warrant Factors that affect the bond component • • Interest rates Credit rating/spreads Coupon Duration Factors that affect the warrant component § • • Stock performance Embedded strike price Common dividend yield and dividend growth rate Stock volatility Life of warrant / call protection 50

Put plus stock plus yield advantage Applying the put-call parity: call + bond = put + stock. Here, put is the right to sell the stock for bond One may treat a convertible bond as yield-enhanced stock plus a put option. • The put option represents the bond floor protection. The strike price is the bond investment value. 51

Bond investment value • Present value of the interest and principal payments discounted at the straight (non-convertible) bond interest rate bond interest value = where P = par value, r = discount rate, C = coupon rate, n = number of periods to maturity. take r = 10% 52

Estimation of the discount rate Use the yield-to-maturity of a similar nonconvertible bond as a proxy. • The apparent deterioration of the creditworthiness of an issue will not be reflected in the convertible price because the value of the conversion option may be rising due to higher share price volatility. 53

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Duration is the weighted average of the times that the principal and interest payments are made. duration = where t is the time of payment Ct is the coupon and/or principal payment i is the market yield. Duration analysis provides a measure how bond values change with changing interest rates. 55

Duration analysis applied to convertibles The approximation for the convertible bond’s interest rate sensitivity where C = conversion value and I = investment value. • The equity component of the convertible bond may dampen the convertible’s interest rate sensitivity, depending on the bond’s equity participation. Hence, convertibles trading high above their investment value will be less sensitive to interest 56 rates.

Duration and coupon For non-convertible bonds, the duration decreases as their coupon increases. This is because higher coupon bonds deliver more cash flows near the start of bond’s life. With convertible feature, the higher coupon rate may lead to lower propensity to convert. The CB then has a longer life, so this leads to higher duration. These two effects are counteracting. 57

Interest rate sensitivity 1. The exercise price is a function of the investment value. An increase in interest rates will lower the investment value. 2. However, the exercise price of the embedded call is reduced. A lower exercise price will increase the value of the warrant. 58

Interest rate sensitivity (cont’d) Basic Int rate Change price + 1% -1% ____________________________ Investment value $847. 84 $812. 75 -$35. 09 884. 74 $36. 90 Warrant value $337. 66 $362. 58 +24. 92 Total $1185. 50 $1175. 33 -$10. 17 $1197. 47 +$11. 92 Percent change -1. 02% $312. 72 -$24. 94 1. 19% 59

Correlation with interest rates Consider the impact of an increase on interest rate The future share price is expected to be higher because of higher drift rate. Due to negative correlation between interest rate and share price (say, the S&P 500 -stock index has a correlation of about minus 0. 5), the share price drops first. Negative correlations normally lower CB value; positive correlations make the CB worth more. In some situation, CBs may have price differences in the range of 10 -15% when correlation moves from 1. 0 to – 1. 0. 60

Pricing of risky convertible bonds One-factor binomial model * stock price process follows binomial random walk * interest rates to be deterministic Two discount rates 1. If the convertible is certain to remain a bond, it is appropriate to use a discount rate corresponding to the creditworthiness of the issuer - risky rate. 2. Suppose the bond is certain to be converted, it is then appropriate to use the riskfree rate. At maturity, the holder will choose the maximum between the par value and the value of stocks received upon conversion. 61

How to account for the creditworthiness of the issuer? The discount rate to be used when we roll back is given by pwu + (1 - p)wd. Here, p is the probability to a node where the discount rate is wu and (1 - p) is probability to a node with wd. The appropriate discount rate is the weighted average of the discounted rates at the nodes in the next time step. 62

conv = value of stocks received if conversion takes place call = call price roll = value given by the rollback (neither converted nor recalled) At each node, the optimal strategy of the holder is exemplified by taking the maximum of min(roll, call) and conv. • The maximum reflects the conversion right, which persists with or without recall by the issuer. • min(roll, call) means the bond value can never shoot beyond the call price. Dynamic programming procedure: max(min(roll, call), conv) 63

Alternative dynamic programming procedure: min(max(roll, conv), max(call, conv)) • The term max(roll, conv) represents the optimal strategy of the holder. • Upon recall, the holder chooses to accept the call price or convert into shares. This can be represented by max(call, conv). The issuer chooses to recall or to abstain from recalling in order to minimize the option value. 64

Example A 9 -month discount bond issued XYZ company with a face value of $100. Assume that it can be exchanged for 2 shares of company’s stock at any time during the 9 months. * It is callable for $115 at any time. * Initial stock price = $50, s = 30% per annum and no dividend; risk-free yield curve to be flat at 10% per annum. * Yield curve corresponding to bonds issued by the company to be flat at 15%. * Tree parameters are: u = 1. 1618, d = 0. 8607, p = 0. 5467, R = e 0. 1 Dt = 1. 0253. * At maturity, the convertible is worth max (100, 2 ST). 65

Binomial tree for pricing a risky convertible bond 67. 49 10% 58. 09 11. 03% 50. 00 11. 59% 104. 85 116. 18 A 134. 98 B 43. 04 13. 51% equity 78. 42 10% 156. 84 D 50. 00 12. 27% E 105. 56 C 98. 00 upper figure: stock price middle figure: discount rate lower figure: value of convertible 37. 04 15%F 96. 32 equity 58. 09 10% 116. 18 bond 43. 04 15% 100. 00 bond 31. 88 15% 66 100. 00

At node D Roll back gives the bond value (0. 5467 156. 84 + 0. 4533 116. 18)e-0. 1 0. 25 = 134. 98. The bondholder is indifferent to conversion or hold, also the issuer is also indifferent as to whether the bond is called; the correct discount rate at node D is 10%. At node F The correct discount rate is 15% since the convertible is contain not to be converted if node E is reached. At node E The correct discount rate is 0. 5467 10% + 0. 4533 15% = 12. 27%. The value of convertible at E (0. 5467 116. 18 + 0. 4533 100)e-0. 1227 0. 25 = 105. 56. 67 The bond should be neither converted nor called.

At node B The discount rate is 0. 5467 10% + 0. 4533 12. 27% = 11. 03% and value of convertible is (0. 5467 134. 99 + 0. 4533 105. 56)e-0. 1103 0. 25 = 118. 34. It is optimal to call the bond at node B so that it causes immediate conversion and leads to $116. 18. The discount rate at node B should be taken to be 10%, since conversion takes place at this node. At node A The discount rate is 0. 5467 10% + 0. 4533 13. 51% = 11. 59%. The convertible value at node A is (0. 5467 116. 18 + 0. 4533 98. 00)e-0. 1159 0. 25 = 104. 85. If the bond has no conversion option, its value is e-0. 75 0. 15 = 89. 36. 68 The value of conversion option = 104. 85 - 89. 36 = 15. 49.