Convertible Bonds

Structuring a convertible issue

 Definitions
• Convertibles bonds are used by firms to
raise funds.
• Convertible securities are bonds (preferred
stocks) that are exchangeable into
common stock at the option of the holder
and under specified terms and conditions.
• Thus the convertible holder owns an
option to convert the bond to common
shares.
 Definitions
• The exercise of the conversion option
does not bring any additional cash to the
firm. The debt on the balance sheet is
simply replaced by common stock. The
reduction of the debt ratio brings in
additional debt capacity.
• The conversion of bonds therefore creates
additional shares which leads to the
dilution for the existing shareholders.
 Example of a convertible
• National Electric Company needs to raise cash
for funding its capital investments to meet the
increased demand. It decides to issue
convertible bonds. The issue is structured as
follows.
• Issued at par value of € 1000, coupon €30 paid
yearly, maturity 10 years. The bond is
convertible into 50 shares of the company, at
any time up to its maturity. The firm can call
back the bond any time after three years from
the date of issue. The redemption value is fixed
at par.
 NEC Convertible
• NEC issues 90,000 convertibles.
• The current trading price of the NEC shares is €16.
• The conversion price is fixed at €2O, which is 25 percent
higher than the current trading price.
• Currently the number of outstanding shares is 11 million.
• If all the convertible holders exercise the conversion
option 4.5 million new shares will be created. The
shareholders equity will increase by €90 million.
• Conversion price=Par value of bond/shares received.
• Generally, the conversion ratio is fixed for life, although
sometimes a stepped up conversion price can be used.
 Parameters of a convertible
• Coupon/interest rate
• Maturity.
• Conversion ratio
• Period when conversion option can be
exercised.
• Call provision
• Par value/ issue price.
• Conditions under which the convertible can be
called back (period, redemption value).
 Apparent advantages of convertibles

• As a sweetener when selling debt. The firm can

sell debt at a lower cost. Less restrictive
covenants. Access debt market, which might be
difficult otherwise.
• Sell common shares at a higher price than those
currently prevailing. Usually, the conversion
price is fixed around 15-25 percent higher.
• Lower dilution ratio.
• Signaling that the current trading price does not
reflect the true price of the share.
 Disadvantages of convertibles
• Although, the convertibles enable firms to
sell at a higher price than the prevailing
price, but if the stock price goes up rapidly,
the firm would have been better off to wait
and issue equity.
• If the price of stock falls, the firm is stuck
with the debt.
• The floatation costs are usually high.
 Accounting principles.
• Cash raised is assimilated in the medium
and long term loans.
• When conversion option is exercised, the
proceeds are transferred to the
shareholders equity.
• The EPS are calculated both on the basis
of no conversion and also if conversion
option is exercised.
 Rationale of Convertible bonds
• Why firms issue convertible bonds?
• Is the reasoning that convertibles
correspond to win/ win situation? If
exercised then the firm reinforces its
equity at a higher price, if not firm is able
to borrow at a cheaper rate.
• If this is the case why firms rarely use
convertibles?
 Rationale
• Analytical studies show that the difference
in interest rates (coupon) between two
firms with different ratings is lower in the
case of convertible issues than in the case
of the same firms issuing straight bonds all
other things being equal.
• This indicates that convertibles are far less
sensitive to risk perception of the issuing
company than straight bonds.
 Valuation of convertibles
• Convertible is a package of two securities: a straight
bond and a certain number of call options.
• This is the simplest form of convertibles.
• Value of a convertible = value of the straight bond +
Value of the conversion option.
• In general, a convertible is composed of a straight bond
and a certain number of embedded options.
• For example, the issuer might include an option to
redeem the convertible at predetermined conditions. This
is often used to force conversion.
 Convertibles and the secondary market

• Convertibles are traded in the secondary

market (considerable demand with the
increase in the number of hedge funds).
• One can talk about three values: the pure
bond value, trading price of the
convertible, conversion value of the
convertible.
• Conversion value= conversion ratio X
trading price of the underlying share.
 Trading price
• Trading price>Max (pure bond value,
conversion value).
• Convertibles are therefore interesting for a
certain category of investors as the
downside risk is limited.
• Convertibles can be classified into three
categories.
• Trading price-Max (pure bond value-
conversion value) =conversion premium.
 Convertibles and the secondary market

• Quasi interest rate securities, when stock price

is very much lower than the conversion price.
• Mixed equity type security, sensitive to both
changes in the interest rate and changes in the
underlying stock price.
• Quasi equity type security, very little sensitive to
interest rate changes, when the stock price is
very much higher than the conversion price.
Relationship between the convertible price and the share
price

Convertible Conversion
value
price

Pure bond value

Stock price
 Conversion
• Voluntary conversion by the holders: if
share price is higher than the conversion
price and if the revenues from conversion
are higher than the revenues obtained by
holding the convertibles.
• Forced conversion
• Purchase in the market
 Problems in valuing convertibles

• As convertible is a package of a straight bond and a set

of call options, the convertibles can be valued by valuing
the two components separately. The convertible, may
include other embedded options. This makes valuation
more complex.
• The straight bond should be valued by discounting the
coupons and the repayment value.
• The call options can be valued using option pricing
models.
 Problems
• It is difficult to estimate the parameters;
• The discount rate for the pure bond can be
obtained from the secondary market and
the yield curves of bonds.
• The maturity is not known.
• How to deal with redemption premium,
sinking fund provisions, green shoe option.
• Estimations of volatility, historical or
implied.
 Settling the terms of a convertible issue

• A firm raising funds through convertibles

will seek to set terms that will cause its
bonds to just clear the market. Investment
banks act as advisers and are part of the
selling syndicate.
• If the convertibles are under-priced, the
current shareholders bear the cost, on the
contrary if the convertibles are overpriced,
the firm will not be able to sell the issue.
 Key variables
• Variables outside the firms’ control:
– The current trading price of the stock
– The expected growth rate of the stock price.
– When would the investors exercise their
options.
– Expected return on the non convertible debt.
– The volatility of the returns on the stock.
 Key variables
• Controllable variables:
– Par value, issue price, maturity value.
– Coupon (interest rate).
– Conversion ratio, conversion price.
– Redemption premium.
– Green shoe option, sinking fund provision.
– Call provision.
 Structuring an Issue: An example

• Let us take the example of the NEC:

– Issue price €1000
– Convertible coupon €30
– Conversion Ratio 50
– Conversion price €20
– No sinking fund provision.
– Call provision.
– No redemption provision.
 Market determined parameters

• Current trading price of the stocks of NEC = €16.

• The volatility of the returns on the NEC stocks =
0.25
• The dividend yield = 2 percent.
• The yield on NEC non convertible debt is 6
percent per annum.
• Given the current growth rate of stock prices the
firm expects that the conversion will take place
in 4 years.
 Pure bond value

t =4
30 1000
P=∑ +
t =1 (1 + k d ) (1 + k d ) 4

k d = 6 percent
P = €896.04
 Option value

S = stockprice = €16
X = Exerciseprice = €20
T = maturity = 4 years
σ = volatility = 0.25
δ = dividendyield = 2%
r = riskfreerate = 4%
Black & Sholes formula for pricing option

−δ .T − r .T
c = S .e N (d1 ) − X .e N (d 2 )
Ln( S / X ) + (r − δ + σ / 2)T 2
d1 =
σ T
d 2 = d1 − σ T
 Call option price

Ln(16 / 20) + (0.04 − 0.02 + 0.252 / 2)

d1 =
0.25 4
d1 = −0.344; N ( d1 ) = 0.364
d 2 = −0.844; N ( d 2 ) = 0.199
c = €1.984
1
Dilution = = 0.710
(1 + 4.5 / 11)
 Convertible Value

• Estimated theoretical value of the

convertible, assuming that the conversion
takes place in 4 years:
– Pure bond value+ conversion value
– €896.04 + 50 x €1.984x0.710=€966.47
– Estimated value is therefore less than the
issue price.
– It would be difficult to clear the issue.
 Structuring the issue
• In the given example, the firm needs to
review the parameters to ensure that the
issue is attractive to the investors.
• Most new issues are sold at a discount.
• The discount depends upon the prevailing
market sentiments and the complexity of
the issues.
• Convertibles are usually bought by the
institutional investors.
 Pricing a convertible issue
• Most convertibles would have a call provision
and may be an option for the holders to sell the
convertible to the issuing firm after a certain
period of time. These convertibles are more
difficult to price.
• These convertibles are a package of several
options, a series of call options owned by the
holder, put options owned by the issuing
company and put options owned by the holder.
 Cost of funds using convertible issues

• Another issue which is interesting for firms

is to know what is cost of raising debt by
issuing convertibles. We can suppose that
convertibles would cost more than pure
debt and should cost less than cost of
pure equity. The CAPM can be used to
estimate the cost of convertibles or what
kind of return the convertible buyers
should expect.
 Cost of convertible debt

equity cos t = ke = rf + β e (rm − rf )

β e = 1.1; (rm − rf ) = 5%, rf = 4%; ke = 9.9%
puredebtvalue Conversionvalue
Cost of convertible = kcd = k d (1 − T ) + Kc
convertiblevalue convertiblevalue
kc = Cost of conversion option
sharevalue
β c = Beta conversion option = β e xN (d1 )
conversionvalue
S = sharevalue = 20.e −.02 x 4 = 18.46
 Cost of convertibles

18.46
β c = 1.1 XN (d1 ) = 5.24
1.409
Cost of conversion option = r f + β c (rm − rf ) = 4 + 5.24 x5 = 30.23%
P C
Cost of convertible funds = k d (1 − T ) + Kc
(P + C) (P + C )
896.04 70.43
K cb = 6%(1 − 0.3) + 30.23
(896.04 + 70.43) (896.04 + 70.43)
K cb = Cost of convertibles = 6.10%