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E Q U I T Y

R E S E A R C H :

I N T E R N A T I O N A L

Convertibles
February 2002

International
For enquiries please
contact:
Christopher Davenport Convertible Bonds
(44-20) 7986-0233
christopher.davenport@ssmb.com
London
A Comprehensive Beginner’s Guide

Luke Fletcher
(44-20) 7986-0125
luke.fletcher@ssmb.com
London
Convertible Bonds – February 2002

Table of Contents

Executive Summary ............................................................................................................................... 3


Summary ................................................................................................................................................ 4
The Basics .............................................................................................................................................. 5
Convertible Bonds, an Investor’s Perspective ........................................................................................ 23
Convertible Bonds, an Issuer’s Perspective ........................................................................................... 30
Convertible Structures............................................................................................................................ 34
Pitfalls and Protection ............................................................................................................................ 44
Convertible Pricing Models.................................................................................................................... 47
Appendix ................................................................................................................................................ 50
Glossary.................................................................................................................................................. 57

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Convertible Bonds – February 2002

This report1 is primarily intended as an aid to investors who wish


to explore opportunities in convertibles and other equity-linked
structures and would appreciate more background on the nature
of the product. We outline practical and theoretical aspects of the
market in six sections. There is also a glossary of terms.

The basics
A convertible is a hybrid security, offering aspects of both equity and straight
bond investment. Using a hypothetical example, the key features of a typical
issue are introduced, defined and their importance illustrated. The interpretation
of a convertible as a derivative instrument is also explained, together with
definitions of such terms as delta and gamma.

Convertibles from an investor’s perspective


From an equity investor’s point of view, a convertible bond resembles the
purchase of a certain number of shares, the purchase of downside protection
and possible purchase of additional yield. From a fixed-income investor’s
perspective, a convertible bond looks like the purchase of a straight bond and the
purchase a right to participate in an element of the appreciation of the underlying
equity. The purchase of a convertible is often perceived as a compromise in
an uncertain world, as it will typically underperform the underlying share in
a rising share price environment and underperform bonds in a falling equity
price environment.

Convertibles from an issuer’s perspective


The same principal of uncertainty applies to issuers of convertibles: with
no presumption concerning the direction of share prices, the issuance of
a convertible can look an attractive option relative to the issuance of pure
equity or pure straight debt.

Convertible structures
Convertibles can be structured across the pure-bond to pure-equity spectrum
to appeal to distinct investor groups. We introduce non-vanilla convertible
structures such as mandatory ‘DECs’ in this section.

Pitfalls and protections


Appreciating the importance of prospectus detail is crucial in convertible
analysis; we identify some protection issues.

Pricing models
We present a brief intuitive description of the nature of the theoretical models
most frequently employed to value convertible bonds.

1
We would like to thank Laura Bordigato for her extensive contribution to this publication.

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Convertible Bonds – February 2002

Summary
A convertible bond is a debt security that can be converted into a fixed
number of shares per bond. If a bondholder decides not to exercise
the option to exchange bonds for shares, the bond will fall due for
repayment of principal at maturity.

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Convertible Bonds – February 2002

The Basics
➤ Convertible bonds as hybrid securities

➤ The ‘vanilla’ structure

➤ Terminology

➤ Convertibles as derivatives

➤ Convertible price sensitivities — the ‘Greeks’

Convertible bonds as hybrid securities


Convertible bonds are hybrid securities, part debt and part equity. They are
corporate bonds that may be exchanged at the option of the holder for a fixed
number of ordinary shares. Convertibles are usually redeemable in cash at
maturity and typically pay a fixed coupon over their life.
From an investor’s point of view, convertibles are attractive relative to straight
corporate debt as they offer the holder the potential to participate in the appreciation
of the underlying equity. Convertibles offer some of the defensive characteristics
usually associated with fixed income paper. They pay regular coupons and are senior
to ordinary share capital, providing an element of downside protection. It is this
defensive quality combined with the prospect of participation in the event of share
price strength that is fundamental to the product’s appeal.
Investors should not conclude that convertibles simply provide investors with the
best of both worlds, however. Equities will typically outperform convertibles in a
rising share price environment, while a company’s straight debt is likely to outperform
its convertible debt in a falling share price environment. An investor would benefit
more from investing directly in the underlying shares of a company (in a rising
price environment), and in its straight debt (if the share price is falling). However,
investment returns are not predictable. The uncertain nature of investment returns
increases the attraction of convertible securities, in our opinion. Convertible
securities offer a hybrid mix of equity exposure and fixed income defensiveness.
At maturity, a convertible is worth whichever is the greater of its cash redemption
value and the market value of the shares into which it converts.
To recap, convertible bonds offer the following:
➤ Upside participation in a rising equity market (thus outperforming straight debt);
➤ Downside protection in a declining equity market (thus outperforming straight
equity); and
➤ Possible income advantage to the underlying shares.
In analysing the performance of convertibles as a separate asset class, one can
observe that they characteristically display levels of volatility and return greater
than straight debt, but lower than straight equity.

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Convertible Bonds – February 2002

The ‘vanilla’ structure


A convertible in its simplest ‘plain vanilla’ form is essentially a corporate bond with
an embedded equity option.
At issue, the investor pays an up-front amount (the ‘issue price’) to receive annual
or semi-annual coupon payments and a cash redemption value at maturity (as with
straight corporate debt). A convertible differs from straight debt in that the holder
has the right to exchange the bond, usually at any time, for a predetermined number
of the company’s ordinary shares (the ‘conversion ratio’), without any extra payment.
In the event of conversion, the investor will renounce title to the corporate bond and
any future income streams from it (including the final redemption payment), in favour
of ownership of the predetermined number of shares underlying the bond. The value
of these shares will naturally be determined by their prevailing market price.
Plain vanilla structures are rare, however, as most convertible bonds include call
features. Below is an example of a simple callable convertible. The example is used
to provide a glossary of terms useful in explaining and valuing convertibles bonds in
general. We use a hypothetical convertible bond, the John Smith Corp. Convertible
EUR 4% 2007. Below are the terms of the bond at issue:

Figure 1. John Smith Corp 4% 2007 — Convertible Data at Issue


Coupon 4%
Coupon Frequency 2 (semi-annual)
Issue Date 1 January 2002
First Coupon Date 1 July 2002
Maturity 1 January 2007
Nominal Value €1000
Issue Price 100
Redemption Value 100
Conversion Ratio 10 shares per bond
Conversion Price €100
Call Protection Hard Call 3 years
Soft Call 2 years; Trigger @ 130%
Call Price 100
Put Feature -
Issue Size €300m
Source: Schroder Salomon Smith Barney Convertibles.

As the convertible contains an option on the shares of the company, the investor
will want to remain aware of the price and other details of the underlying.

Figure 2. John Smith Corp — Ordinary Share Data


Stock Price €80
Stock Volatility 25%
Dividend per Share €2
Dividend Yield 2.5%
Source: Schroder Salomon Smith Barney Convertibles.

During the life of the convertible, an investor will wish to monitor the following
characteristics of the convertible: convertible price, parity and premium. An investor
will also monitor the yield of the bond compared to yields on fixed income paper
with similar characteristics (maturity, coupon, issue size).

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Convertible Bonds – February 2002

John Smith Corp Convertible EUR 4% 2007 has the following characteristics:

Figure 3. John Smith Corp 4% 2007 — Convertible Data at Issue


Convertible Price 100
Parity 80
Premium 25%
Current/Running Yield 4%
Yield To Maturity 4%
Source: Schroder Salomon Smith Barney Convertibles.

Terminology
Quotation Convertible bonds are usually identified by issuer name (John Smith Corp), currency
(EUR), coupon (4%) and maturity date 2007, though this may be abbreviated to issuer
name, coupon and maturity.
Coupon Coupons are the interest payments made on a bond by the issuer. The coupon
payments are typically fixed at issue and are a percentage of the bond’s nominal
value. For the John Smith Corp Convertible EUR 4% 2007, the coupon payments
are calculated as follows:
CouponPaymentPerYear = Coupon * No min alValue
CouponPaymentPerYear = 4% * € 1,000
CouponPaymentPerYear = € 40
As the John Smith Corp Convertible EUR 4% 2007 pays coupons semi-annually,
half of this €40 amount will be paid to investors in the bond on each coupon date
(1 July and 1 January each year).
Accrued interest Interest accrues between coupon payment dates. Purchasers of convertible bonds
generally have to compensate the seller for the interest accrued from the time of
the last coupon payment date, to the date they purchase the bond.
An investor buying the John Smith Corp Convertible EUR 4% 2007 for settlement
4 June 2003, will pay the ‘clean price2’ of the bond, plus the interest accrued on the
bond since the last coupon payment date (1 January 2003).
The interest accrued on the John Smith Corp Convertible EUR 4% 2007 for the
above purchase would be calculated as follows:

æ ActualNumberofDays ö
AccruedInterest = çç ÷÷ * (Coupon * NomValue )
è 365 Days ø
æ 154 ö
AccruedInterest = ç ÷ * (4% * € 1,000 )
è 365 ø
AccruedInterest = € 16.88

2
The clean price is the one conventionally used for quoting the price of both straight-bonds and the convertibles. It is expressed

as a percentage of nominal value and exclusive of accrued interest.

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Convertible Bonds – February 2002

If we assume that the convertible’s ‘clean price’ on 4 June 2003 is 102, an investor
purchasing the bond would pay:
Purchase Pr ice = (Clean Pr ice * No min alValue ) + AccruedInterest
Purchase Pr ice = (102% * € 1,000) + € 16.88
Purchase Pr ice = € 1,036.88
The convertible price inclusive of accrued interest is also referred to as the
convertible’s ‘dirty price’.
It is worth noting the following points:
➤ According to the prevailing market convention, the ratio that expresses the time
over which interest accrues is given by the actual number of days between the
last coupon and the settlement date, divided by 365 days (in the year). Some older
bonds specify calculation of accrued interest with respect to a 30-day month and
360-day year, however.
➤ By historical convention, French convertible bond prices are quoted in ‘dirty
price’ format (inclusive of accrued interest) and in nominal terms, not as a
percentage of the nominal value.
Maturity The maturity date is the date on which the issuer must redeem unconverted bonds
at the redemption price.
The John Smith Corp Convertible EUR 4% 2007 would mature on 1 January 2006 at
100% of its nominal value or €1,000 per bond. However, it would be rational for
holders of the bonds to convert them prior to the final maturity date if the market value
of the shares into which they convert exceeds the cash redemption value of the bond.
Nominal value A convertible’s nominal value may also be referred to as its face value. Each John
Smith Corp Convertible EUR 4% 2007 convertible has a nominal value of €1,000.
A nominal value of 1,000 (in the relevant bond currency) is often the market
standard in the Euroconvertible markets, though it is typically ¥1,000,000 in the
Japanese domestic and Euroyen markets. As described above, the convertible’s
price, issue price and redemption value are all expressed as a percentage of the
bond’s nominal value; French convertibles are an exception to this rule, however,
being quoted in unit form.
Convertible price The convertible price is the price at which it trades in the market. It is generally
quoted as a percentage of its par amount.
The major influences on the convertible price are as follows:
➤ Movements in the underlying stock price;
➤ Underlying stock volatility perceptions;
➤ Changes in the credit perception of the issuer;
➤ Movements in interest rates on risk-free securities;
➤ Prospective dividends; and
➤ The passage of time.

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Convertible Bonds – February 2002

Issue price When the issue price of the convertible is equal to the bond’s nominal value, we say
that the convertible has been issued at ‘par’. The term ‘par’ is often used to represent
100% of the face value of a bond. The John Smith Corp Convertible EUR 4% 2007
was issued at par, as its issue price (€1,000) was equal to 100% of the convertible’s
nominal value.
If a bond is issued at a price below its nominal value, it is referred to as an ‘original
issue discount’ (OID) bond.
The influence of market forces will cause the price of a convertible bond to deviate
from its nominal or face value over its life.
Redemption value At maturity, a convertible’s redemption price is often equal to its issue price,
implying redemption at the bond’s nominal value.
Where the redemption value of a bond is above its nominal value, it is said to
redeem at a premium to par and is a ‘premium redemption’ structure. In this case,
the redemption price of the convertible is normally expressed as a percentage
of its original issue price (and nominal value).
The John Smith Corp Convertible EUR 4% 2007 was issued at 100% of face
value and will redeem at 100% of face value.
Conversion ratio The number of shares a convertible can be exchanged for is represented by its
‘conversion ratio’. Though this ratio is determined initially at issue, it will usually
be adjusted to account for stock splits, special dividends and other dilutive events.
The John Smith Corp Convertible EUR 4% 2007 has a conversion ratio of 10.
This means that each John Smith Corp bond of €1,000 nominal can be converted
for 10 John Smith Corp ordinary shares.
The conversion ratio is calculated by dividing a convertible’s nominal value by its
conversion price.
No min alValue
ConversionRatio =
Conversion Pr ice
Conversion price The price at which underlying shares are indirectly purchased, assuming conversion
takes place and the convertible has been purchased at par, is shown by the ‘conversion
price’. Although no cash changes hands upon conversion, we can determine the price
at which a convertible investor initially buys shares by dividing the face value of the
bond by its conversion ratio.
No min alValue
Conversion Pr ice =
ConversionRatio
The conversion ratio on the John Smith Corp Convertible EUR 4% 2007 is
calculated as follows:

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Convertible Bonds – February 2002

No min alValue
Conversion Pr ice =
ConversionRatio
€ 1,000
Conversion Pr ice =
10
Conversion Pr ice = € 100
The €100 conversion price can be thought of in option terminology as the
convertible’s ‘strike price’. An investor may convert the bond into the underlying
shares at any time. The investor will receive 10 shares having theoretically
paid €100 for each of them, regardless of the prevailing stock price at the time
of conversion.
An investor in a convertible bond estimates the likelihood of (eventual) conversion
by monitoring the course of the stock price.

If the share price > conversion price, the convertible is said to be


in-the-money

If the share price < conversion price, the convertible is said to be


out-of-the-money

If the share price is reasonably close the conversion price, the


convertible is said to be at-the-money

The share price of John Smith Corp at the time of the convertible issue is
€80 (see Figure 3 above). As the conversion price on the John Smith Corp Convertible
EUR 4% 2007 (€100) is above the share price of the stock, the convertible is said to
be out-of-the-money. If the stock price were to approach and rise above €100, the John
Smith Corp Convertible EUR 4% 2007 would gradually become classified as more
at-the-money and then in-the-money.
Parity Parity is the market value of the shares into which a convertible bond may be
converted. Parity is expressed in terms of the bond currency and is normally quoted
as a percentage of par, except in the case of French bonds where it is quoted relative
to a bond’s nominal value.

Parity =
(ConversionRatio * CurrentShare Pr ice)
No min alValue
For the John Smith Corp Convertible EUR 4% 2007, parity is calculated as follows:

Parity =
(ConversionRatio * CurrentShare Pr ice)
No min alValue
Parity =
(10 * € 80)
€ 1,000
Parity = 80%

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Convertible Bonds – February 2002

Parity on the convertible will move in line with changes in the underlying share
price. Additionally, movements in the exchange rate between the stock and bond
will influence parity on a cross-currency bond (where the bond currency differs
to that of the underlying equity).
Premium Premium on a convertible is the difference between the bond’s price and its equity
value or parity. Premium is expressed as a percentage of parity.

Pr emium =
(Convertible Pr ice − Parity )
Parity
The premium on the John Smith Corp Convertible EUR 4% 2007 is:

Pr emium =
(Convertible Pr ice − Parity )
Parity

Pr emium =
(100 − 80)
80
Pr emium = 25%
A convertible’s premium will change with movements in convertible price and
parity. It is the difference between the two and represents how much more the
investor is paying to control a given number of shares via the convertible.
One justification for the payment of a premium is the downside protection offered
by a convertible, over the life of the bond. A convertible investor retains the option
to receive the redemption value of the bond at maturity instead of converting into
the underlying shares (which may fall in price).
Yield advantage3 Yield advantage is another justification for paying a premium (in cases where the
current yield on the convertible is greater than the dividend yield of the common
stock). In many cases, while waiting for the optimal moment to convert, an investor
receives extra income from investment in the convertible. In our example, the John
Smith Corp Convertible EUR 4% 2007 will pay €40 in income per annum.
From Figure 3, we can see that the underlying stock has a dividend of €2 per share.
The shares underlying the convertible would return only €20 a year. Convertible
investors will receive €20 more in income than investors who bought the equivalent
number of John Smith Corp shares will.
ConvertibleYieldAdvantage = ConvertibleRunningYield − EquityDividendYield

Breakeven ‘Breakeven’ on a convertible may be thought of as the length of time (in years)
that it takes for a convertible’s premium to be made up by the yield advantage of the
convertible. ‘Breakeven’ is a crude measure that makes no adjustment for the present
value of future monetary cash flows.

3
For a definition of Convertible Running Yield and Equity Dividend Yield, see Current or running yield below.

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Convertible Bonds – February 2002

Absolute Pr emium
Breakeven =
[Coupon − (DividendPerShare * ConversionRatio )]
For the John Smith Corp. Convertible EUR 4% 2007:
Absolute Pr emium
Breakeven =
[Coupon − (DividendPerShare * ConversionRatio )]
€ 200
Breakeven =
[€ 40 − (€ 2 *10)]
200
Breakeven =
20
Breakeven = 10 years
We argue above that the yield advantage of a convertible relative to its underlying
share is a justification for a convertible’s premium. However yield advantage is
seldom the only justification. In this case it would take 10 years for the extra income
on the bond to offset the premium on the convertible. The John Smith Corp
Convertible EUR 4% 2007 only has a five-year maturity.
Current or running yield The current yield on a convertible is similar to the dividend yield on a stock;
both are defined below.
DividendPerShare
DividendYield =
CurrentShare Pr ice
Coupon
RunningYield =
CurrentConvertible Pr ice
At issue, the running yield on the John Smith Corp Convertible EUR 4% 2007 was:
Coupon
RunningYield =
CurrentConversion Pr ice
€ 40
RunningYield =
€ 1,000
RunningYield = 4%
A convertible’s current or running yield will change over the life of a bond as the
convertible price varies. For convertibles that are by convention quoted with accrued
interest included in the price, it is common to see the current yield expressed as the
coupon divided by the quoted price, adjusted for the unit size. As this is inconsistent
with the use of the term in relation to the majority of convertibles that are quoted in
clean price form, in some cases analysts will use a notional clean price.

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Convertible Bonds – February 2002

Yield to maturity (YTM) A bond’s yield to maturity (YTM) is the rate of return that an investor will receive
if the bond is held to maturity4. A convertible’s YTM is inversely correlated to
movements in its price: the higher the convertible price, the lower its YTM and
vice-versa, other things being equal.
Bond floor, or A convertible’s bond floor, or investment value, is calculated by considering
investment value the fixed income attributes of a convertible security alone. The investment value
of a convertible is found by discounting to present value the cash flows of the
convertible, (its coupons and redemption value). This is the same calculation that
would be applied to a normal fixed income security to determine its value.
The discount rate generally applied to a bond’s cash flows is the risk-free rate
relevant for the maturity of the bond, plus a credit spread, which measures the credit
quality of the issuer5. Without its embedded conversion option, a convertible would
be worth no more than its fixed income value (its bond floor, or investment value).
Using the risk-free rate plus credit spread method described above, the investment
value on the John Smith Corp Convertible EUR 4% 2007 bond at issue was
89.91% of its par value. Please refer to the Appendix for a more detailed breakdown
of this calculation.
The Libor, or swap curve (for the relevant underlying currency) is conventionally
used in the Euroconvertible market as a proxy for the risk-free rate6. When choosing
a credit spread, one is forced to make an assumption on the credit quality of the issuer,
by inspecting the credit spread on corporate bonds for similarly rated issuers, for
example. The credit spread assumption is fundamental to the valuation of a convertible
as it can significantly affect the measures used to judge the merits of a bond.
The bond floor should provide the convertible price with a minimum price floor,
subject to prevailing interest rates and the credit of the issuer. In theory, independent
of the performance of the underlying share price, the convertible should be worth at
least its bond floor. However an investor should be aware that a dramatic fall in the
share price of a company can affect the perception of the correct credit level for that
issuer, which will tend to lower the perceived level of the bond floor.
Risk Premium A convertible’s risk premium is calculated as the difference between its price and
bond floor, expressed as a percentage of the bond floor.

Risk Pr emium =
(Convertible Pr ice − BondFloor )
BondFloor

4
This is a somewhat simplistic definition as it ignores the reinvestment of coupon interest. For a more complete definition of YTM,

please see the Appendix.

5
An alternative method for calculating the bond floor considers the spot yield curve and discounts each future payment using the

appropriate spot rate plus credit spread.

6
Ideally sovereign debt of the nation associated with the currency in question should be used. For example the Treasury yield curve
should be used for US dollar bonds. Though swap rates are higher than Treasury rates, there is a compensatory effect in that the

spread over swaps for a given corporate bond will be tighter than the spread over Treasuries.

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Convertible Bonds – February 2002

The risk premium on the John Smith Corp. Convertible EUR 4% 2007 at issue was:

Risk Pr emium =
(Convertible Pr ice − BondFloor )
BondFloor
Risk Pr emium =
(100 − 89.91)
89.91
Risk Pr emium = 11.22%
The difference between a convertible’s price and its bond floor can be seen as the
value that the market places on the option to convert. The risk premium measures
how much of a ‘premium’ to the bond floor a fixed-income investor is required to
pay for an option on the underlying shares.
Call protection Many convertibles have call features. A call feature gives the issuer the right to
redeem a convertible before maturity (from the call date) at a predetermined price
(the call price). The call price of a bond is typically at par, or at the accreted value
of the bond, in the case of an OID or premium redemption security.
The John Smith Corp Convertible EUR 4% 2007 can be called at par, or 100% of
its nominal value. However, it cannot be called for at least three-years (the bond
has three-years of ‘hard non-call’ (HNC) protection), as shown in Figure 2. HNC
protection has value to a convertible investor. It guarantees the holder of the bond
exposure to the underlying share and to any yield advantage that this may imply
for an identifiable period of time.
The John Smith Corp Convertible EUR 4% 2007 cannot be called unconditionally
until after this initial three-year, HNC period has expired, however. The conditions
of the bond’s ‘soft call’ (sometimes referred to as its provisional call), must also be
satisfied. A ‘soft call’ usually requires the price of the shares underlying a convertible
to trade above a predetermined percentage of the initial conversion price, for a
specified period of time (often 20 of 30 consecutive business days). Our notional
bond has two years of ‘soft call’ protection following its three years of HNC
protection. The issuer can only call the bond if the stock trades at 130% of the
initial conversion price, or €130, for at least 20 days.
In addition to the call price, the company issuing a call notice will generally have
to pay investors the amount of interest that has accrued on the security between
the previous coupon payment date and the call date.

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Convertible Bonds – February 2002

When a bond is called, investors have the right to choose whether


to accept the call price plus accrued interest7, or to convert into the
underlying shares. In making this investment decision, an investor
should compare the value of the call price plus accrued interest with
the current market value of the shares they would receive on conversion,
parity; (note that on conversion, investors normally forfeit any
accrued interest).

If parity is greater than the call price plus accrued interest, the issuer’s
decision to call the bond back will, in effect, force investors to convert
into shares.

The intention behind most call decisions is to force conversion. If forcing equity
conversion is the company’s ultimate goal, the issuer may delay calling the bond
until parity is well above the call plus accrued interest price. This is to ensure that
movements of the share price during the required notice period of the call (typically
between 30 and 90 days), will not affect the result of the call (investors will make
their decision to convert or redeem their bonds during the notice period).
Sometimes it may be rational for an issuer to call a bond even if parity is well
below the call price. This may be the case either if interest rates have fallen or
if the company’s credit has improved and so that it may be able to refinance on
more attractive terms. Calls for cash redemption are much rarer than calls
forcing conversion.
Put features While many convertibles have call features, investor put options are less common.
A put feature gives the holder of the convertible the right to require the issuer to
redeem a convertible on a predetermined date or dates prior to maturity at a fixed
price. The issuer is usually required to redeem the convertible for cash. However,
some convertibles give the issuer the option of delivering shares, or a mix of cash
and shares, as long as the market value of the shares issued or mix paid is at least
equivalent to the predetermined cash value of the put.
Issue size The issue size is the nominal amount of convertible bonds sold by the issuing firm.

Convertibles as derivatives
A convertible is a hybrid instrument. We can think of parity as the equity component
of a convertible and the bond floor as its fixed-income component. This being the
case, the premium to parity of a convertible represents the cost to an equity investor
of owning the bond. Similarly, a fixed income investor will consider the risk
premium on a convertible as the cost of owning it.

7
Assuming the call notice specifies payment of accrued interest. In instances where the call date falls on a coupon payment date,

this issue does not arise.

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Convertible Bonds – February 2002

The different views taken by fixed income and equity investors on the make up
of a convertible is consistent with the very different views each have on the value
underlying a convertible.
Equity investor Equity investors tend to view a convertible as a combination of:
viewpoint
➤ Equity — a convertible holder has control over a fixed number of shares.
In terms of value, an investor ‘owns’ parity.
➤ A put option — a convertible holder has control over the underlying shares, but if
the stock price falls, the investor can choose not to convert and instead to receive
a cash redemption amount at maturity. It is sometimes easier to think of the right
not to convert as a put option, if one imagines the investor automatically being
delivered the fixed number of shares at maturity and then having the (notional)
right to sell the package of shares back again at the cash redemption amount.
The rational investor will exercise this right if the redemption value is greater
than parity; the investor pays a premium to own this embedded put option.
➤ A dividend swap — a convertible holder indirectly owns a certain number
of shares but receives coupons instead of dividends until the earlier of maturity
or conversion. This is equivalent to owning a dividend swap that gives the
equity investor coupons in exchange for dividends. Assuming there is an income
advantage for the convertible holder, the investor will pay a premium to own
this embedded dividend swap.
Fixed income Fixed income investors tend to view convertibles as a combination of:
investor viewpoint
➤ A straight bond — a convertible holder owns a straight corporate bond that pays
coupons and has a cash redemption value at maturity. A convertible’s bond floor
represents this straight bond value.
➤ A call option — a convertible holder has the right to exchange his corporate
bond for a predetermined number of the company’s ordinary shares, usually
at any time. This is equivalent to owning a call option that gives the fixed-income
investor the right to buy shares by giving up the convertible. At maturity this
is equivalent to a call with a strike price approximately equal to the conversion
price (for a single currency bond). Unlike a conventional option, there is no cash
payment on exercise. The converting bondholder ‘gives up’ the straight bond
he controlled until the moment of conversion though has paid a premium to
own the embedded call option (the risk premium).
We can show graphically how the value of a convertible and its debt and equity vary
with the share price:

16
Convertible Bonds – February 2002

Figure 4. Convertible Price, Parity and Bond Floor against Share Price

Premium

Share Price
Bond Floor Parity Convertible

Source: Schroder Salomon Smith Barney Convertibles.

Figure 5. Risk Premium against Share Price

Risk premium

Bond Floor Convertible

Source: Schroder Salomon Smith Barney Convertibles.

We note that:
➤ The bond floor of a convertible tends not to be correlated with movements in the
share price, unless a fall in the stock price is perceived to affect the credit quality
of the issuer (shown in the extreme left of Figures 4 and 5 above).

17
Convertible Bonds – February 2002

➤ Parity varies proportionally with the share price (in non-cross currency bonds),
as it is equal to the share price (expressed in the bond currency) multiplied by the
conversion ratio. In single currency bonds the slope of the parity line represents
the conversion ratio.
➤ Figure 4 shows how investors purchasing shares via a convertible forfeit
a degree of equity appreciation, as the convertible price is less sensitive
to share price variations than pure equity.
➤ The difference between the convertible price and the bond floor (the risk
premium) represents the value of the embedded call option to a fixed
income investor.
➤ The difference between the convertible price and parity (premium) represents
the value of the embedded put option (downside protection) and the dividend
swap (yield advantage) to an equity investor.
➤ Figure 4 illustrates how, as the equity price rises, the premium narrows to
a point where the convertible derives its value from the equity component only.
When the share price rises, both the value of the put option and the value of the
dividend swap decrease. The put value decreases as it becomes less likely that
investors will exercise the option to ‘sell’ shares for cash redemption at maturity.
Simultaneously the dividend swap value may decrease in a callable bond,
as it becomes more likely that the issuer will call the bond back and investors
expect the period of yield advantage to shorten.
➤ When the equity price declines, the premium expands. The more the share price
falls, the more the convertible price is supported by and trades increasingly in
line with its bond floor.

Convertible price sensitivities — the Greeks


A convertible’s price is positively correlated with:
➤ The underlying stock price — the higher the underlying stock price, the greater
the value of parity (the equity component of a convertible), so the greater the
value of the convertible.
➤ Volatility of the underlying stock — the higher the volatility of the underlying
share, the greater the value of the convertible’s embedded option (put or call,
according to the equity or the fixed-income investor’s perspective), so the
greater the value of the convertible.
➤ Issuer credit quality —the better the credit quality of the issuer, the lower the
credit spread over Libor or the benchmark government yield curve required
to discount a bond’s coupon payments and redemption value. The lower the
discount factor applied to a bond’s cash flows, the higher its bond floor and
the greater its value.
➤ Call protection — the longer the call protection on a bond, the longer
the guaranteed period of yield advantage and the greater the value of the
convertible’s embedded dividend swap, so the greater the value of the
convertible. Longer options also tend to be more valuable than shorter ones.

18
Convertible Bonds – February 2002

A convertible’s price is negatively correlated with:


➤ Stock dividends — the higher the dividend, the lower the yield advantage of
the convertible over the share.
➤ Interest rates — the higher the prevailing interest rate, the higher the discount
rate for coupon payments and redemption value, the lower the bond floor and
convertible’s value. It is also true that the higher the interest rate, the greater
the value of the convertible’s embedded call and so the greater the convertible’s
value. Thus a convertible’s price is less sensitive to interest rates movements
than an otherwise identical straight-bond.
We can describe the impact of various factors on the price of a convertible using
the following concepts, which are more commonly referred to as the ‘Greeks’;
the ‘Greeks’ are outputs of convertible pricing models.

➤ Delta — measures the sensitivity of the convertible price to changes


in parity

➤ Gamma — measures the sensitivity of delta to changes in parity

➤ Vega — measures the sensitivity of the convertible price to changes


in underlying stock volatility

➤ Rho — measures the sensitivity of the convertible price to changes


in interest rates

➤ Theta — measures the sensitivity of the convertible price to the


passage of time

Delta
Delta measures the sensitivity of a convertible’s price to changes in parity.
It is the equity sensitivity of the convertible, in absolute terms. Conventionally,
delta is expressed as the change in convertible price for a one-point change in
parity. Thus, a 40% delta means that if parity rises by 1 point, the convertible
price will rise by 0.4 points (40% of the one-point change in parity).
Delta changes along the convertible price curve. The higher the value of parity, the
higher the convertible’s delta. The range of delta along the convertible curve varies
between 0% and 100%. As the convertible’s price moves from out-of-the-money
to in-the-money (due to a rise in the underlying share price and therefore parity),
its delta will increase as the convertible’s equity component becomes more significant.
Further comments on delta from a theoretical perspective are available in the Appendix.

Gamma
Gamma is the rate of change in delta for movements in the underlying share price.
Conventionally, it is expressed as the change in delta for a one-point change in parity.
For material share price moves, delta can be a poor guide to the sensitivity of the
convertible to a move in parity. In general the convertible is more equity sensitive
in rising markets and less sensitive in falling markets than the delta would suggest.
Gamma is the measure of the intensity of this effect.

19
Convertible Bonds – February 2002

This topic will be covered later when discussing ‘gamma trading’. A theoretical
treatment of gamma and a chart of its sensitivity to the share price level are
available in the Appendix.

Vega
Vega is the sensitivity of the convertible price to changes in the volatility of the
underlying stock. Conventionally, vega is expressed as the change in the fair value
of the convertible for a one percentage point increase in the assumption for
stock volatility.
In order to find a theoretical value for a convertible (its theoretical ‘fair value’),
it is necessary to input assumptions to a convertible pricing model:
➤ A credit spread (or spread over Libor), used to establish the rate for discounting
the bond’s coupon payments and its redemption value;
➤ Dividends on the underlying share, to maturity; and
➤ A volatility assumption for the underlying stock.
Vega measures the sensitivity of fair value to changes in the assumed level of
stock volatility. There are no short names in common use for the dividend and
spread sensitivity.
The convertible price curve is set for an assumed level of stock volatility:
it shows how the convertible price changes when parity changes, given the
assumed volatility.
In approximate terms the closer the convertible is to being at-the-money, the more
sensitive the convertible price is to changes in assumed volatility. A chart of vega
against parity is available in the Appendix.

Rho
Rho measures the sensitivity of a convertible price to movements in interest rates.
Conventionally, it is expressed as the change in convertible price for a given one
basis point move in interest rates (a parallel shift in the whole yield curve).
Rho is the fixed income sensitivity of the convertible just as delta was defined as
the equity sensitivity.
Delta increases as parity (the equity component of the convertible) increases.
Conversely, rho increases when parity decreases, or as the convertible starts trading
more on its fixed interest characteristics.
A more thorough treatment of Rho is to be found in the Appendix.

Theta
Theta is the change in convertible price with the passage of time. Conventionally,
it is expressed as the percentage change in convertible price for the passage of one
day, all other things being equal. For a near-the-money convertible, the passage of
time is normally negative for the value of a convertible, the time decay of the option
element outweighing any upward drift in the bond floor (see Figure 23 in the Appendix).

20
Convertible Bonds – February 2002

Convertible bonds, a simple classification


Figure 6 reproduces the chart showing convertible behaviour for different share
price levels. It is used here to generate a simple classification system for convertibles
in different share price zones.
Figure 6. Behaviour of Convertible in Different Share Price Zones

Busted OTM ATM ITM Discount

Share Price
Parity Bond Floor Convertible

Source: Schroder Salomon Smith Barney Convertibles.


The classification refers to the relationship of the stock price to the conversion price.
To reiterate our earlier comment;

If the share price > conversion price, the convertible is said to be


in-the-money

If the share price < conversion price, the convertible is said to be


out-of-the-money

If the share price is reasonably close the conversion price, the


convertible is said to be at-the-money

We add here two other, more extreme classifications:

If the share price falls dramatically, leaving the convertible trading at


a price so deeply out-of-the-money that its equity component becomes
immaterial, it is sometimes referred to as busted debt8, or a high
yield convertible

If the share price rises dramatically and parity is greater than the
convertible price (ie a negative premium), the convertible is said to
trade at a discount9 to parity

8
The phrase ‘busted debt’ or ‘busted convertible’ has no precise definition. Many will not apply the description
unless there has been a deterioration of the credit as well as a fall in parity.

9
A discount convertible trades at a negative premium to parity. Arbitrage opportunities from exploiting any anomaly

are frequently hindered by market inefficiencies.

21
Convertible Bonds – February 2002

At issue a convertible is, generally speaking, priced slightly out-of-the-money.


However, convertibles in each category outlined above will tend to have certain
premium, delta, gamma and rho characteristics. Figure 7 gives a description of each
category in terms of the typical value of the parameters for a basic convertible:
Figure 7. Typical Characteristics of Convertible Bonds Categories
Busted OTM ATM ITM Discount
Premium >100% 100-40 40-10 <10% <0%
Delta 0-10% 10-40% 40-80% >80% 100%
Gamma None Varied High Low None
Rho High High Low None None
Source: Schroder Salomon Smith Barney Convertibles.

It is possible to draw conclusions about an investor’s priorities from the nature of the
convertibles owned:
➤ A high premium over parity may indicate that the investor attaches particular
importance to downside protection and yield advantage.
➤ Delta represents the equity sensitivity of a convertible. It indicates the level of
exposure an investor wishes to have to the equity market.
➤ Since gamma is a measure of how responsive the equity sensitivity of a
convertible is to share price movements, high gamma bonds are natural holdings
for those anticipating dramatic share price movements (in either direction).
➤ Rho represents the interest rate sensitivity of a convertible. A high level of
rho indicates that the convertible is trading predominantly as a debt instrument.
Holders of such bonds are likely to be mainly interested in their
straight-bond component.
Thus it is possible to draw conclusions about a bondholder’s investment objective
from the characteristics of the securities owned. We identify the objectives and
strategies of different investor types and analyse their preference for different types
of convertible below.

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Convertible Bonds – February 2002

Convertible Bonds, an Investor’s


Perspective
➤ Convertibles for equity investors

➤ Convertibles for fixed income investors

➤ Convertibles for hedge funds

➤ Change in the investor base over the life of the convertible

Convertibles for equity investors


We stated above that equity investors perceive the purchase of a convertible as
equivalent to the purchase of a certain number of shares, the purchase of downside
protection and the purchase of possible yield advantage.
Convertible = Equity + Downside Pr otection + YieldAdvantage
The downside protection over the life of the convertible can be seen as an embedded
European put option to sell shares at the redemption price at maturity. This right will
be exercised if parity on the bond is less than the cash redemption value (the strike
price of the notional put) at maturity.
The yield advantage can be characterised as an embedded dividend swap, which
gives the investor coupons in exchange for dividends until the convertible bond is
converted or redeemed.
Whatever other attributes an equity investor looks for in a convertible, it is likely
that they will maintain a preference for bonds whose risk and return characteristics
do not deviate radically from equities themselves. Convertibles that trade on
very low premiums are obvious candidates for equity investors, for example.
Such convertibles typically have high deltas and a relatively distant investment
value (ie a high-risk premium).
Some equity investors are attracted by the income characteristics of certain
convertibles. This is particularly so if the premium paid is quickly made up for by
an income advantage over the underlying shares. Instances in which the premium
is amortised before the first call date of the convertible will have obvious appeal
(see the definition of ‘breakeven’ on page 13 for more details).

The cash for cash switching strategy


An investor selling shares to buy a bond convertible into the same underlying shares
on a cash for cash basis is reducing the number of shares he controls, assuming the
convertible stands on a premium.
From our notional example earlier, if John Smith Corp shares are trading at €125,
an equity investor with 40,000 shares has a cash investment of €5 million.

23
Convertible Bonds – February 2002

If the John Smith Corp Convertible EUR 4% 2007 is trading at 129% (clean) on
a premium of 3.2%, the equity investor’s €5 million potential sale proceeds would
purchase €3,876,000 nominal of the convertible bond, ignoring accrued interest
effects; (the €5 million proceeds divided by the clean price of the bond (129%)).
As each bond converts into 10 shares (the conversion ratio of the bond), the investor
in reality ‘buys’ control of only 38,760 shares (from 40,000 above).
Impact of a From an equity investor’s perspective, when the share price underlying a convertible
share price rise rises, the convertible price will tend to rise, but by less than parity. Thus convertibles
will typically underperform the underlying share because the premium contracts.
Intuitively, the value of the downside protection will decrease and the risk of losing
the yield advantage will increase due to increased call risk. The premium is actually
the amount that an equity investor stands to lose when switching into a convertible
if the share price rises.
Impact of a When the underlying share price falls, the convertible price will tend to fall,
share price fall but by less than parity because the premium expands on the downward move.
Thus convertibles will tend to outperform the underlying shares because of premium
expansion. The premium expansion is actually the amount that equity investors
stand to gain from switching into a convertible if the share price falls.
Equity investors switching into convertibles at very low premium levels
(and consequently, high delta levels) often get a highly asymmetric risk/return profile:
➤ If the underlying shares keep rallying the convertible price will rise on almost
a 1:1 basis, because the premium is so low (its delta will be tending towards
100%). Though the convertible may underperform the underlying shares,
this underperformance should be slight.
➤ If the underlying shares fall, the convertible will fall but the decline will be
softened by expansion of the bond’s premium. In such a scenario, a convertible
will tend to outperform the underlying shares.
Thus the cash-for-cash switching strategy suggests:

➤ Equity investors should consider selling shares and switching


into convertibles when the premium is very low because of the
asymmetrical nature of prospective returns

➤ If the share falls and the premium widens, investors should consider
switching back into shares to crystallise a profit, bearing in mind that
a rally in the share price could wipe out his gain

➤ This strategy may outperform simple ‘buy and hold’ strategies for
either shares or convertibles in a range-bound but volatile market;
investors following this strategy will tend to buy in-the-money
convertibles (high delta, low premium)

24
Convertible Bonds – February 2002

Convertibles for fixed income investors


For a fixed income investor, the purchase of a convertible is equivalent to the
purchase of a straight bond plus the purchase of upside participation in any underlying
share price appreciation. The straight-bond component is the bond floor and upside
participation comes from the embedded call option to purchase the underlying shares.
The risk premium is the premium to the bond floor a fixed-income investor pays
in order to gain access to participation in upward moves in the underlying shares.
Implications of share When the underlying share price (and consequentially, the convertible price)
price moves rises, the risk premium on the convertible will expand, as the call becomes more
in-the-money.
When the underlying share price (and convertible price) falls, the risk premium
contracts, as the call becomes more out-of-the-money. The convertible price will
fall, but as long as the fall in the underlying share price does not affect the credit
quality of the issuer, the convertible’s bond floor (its fixed interest value) should
support its price.
Risk premium expansion is the potential advantage that a fixed income investor
stands to gain by switching from a straight bond into a convertible, if the underlying
share price rises. Conversely, the risk premium can be seen as the amount that a fixed
income investor stands to lose from switching by a straight bond into a convertible,
if the underlying share price falls.
The position of convertibles as a ‘halfway house’ between fixed income and straight
equity is especially relevant for the many institutional investors who are bound by
a requirement to invest only in bonds, or to keep a large proportion of their portfolio
in fixed-income securities. As convertibles are often classified as bonds, fixed-income
investors may use them to inject equity elements into their portfolios without losing
the support offered by the bond floor.

Out-of-the-money convertibles
Traditionally, fixed-income investors with a low risk profile have preferred to buy
out-of-the-money convertibles since they trade close to their bond floor and can offer
inexpensive call options on the price performance of the underlying shares. Despite
offering only a small element of equity sensitivity, an out-of-the-money call still
gives an investor the chance to participate in any appreciation of the underlying stock
(even if only moderately, on account of the low delta that typifies an out-of-the-money
convertible security). On the other hand, they will have paid almost nothing for this
option, so they will lose little if the underlying share price falls. Since rho is high on
an out-of-the-money convertible, it will respond to movements in interest rates and
credit spreads in a similar fashion to a straight bond. As the underlying share price
rises, moving the convertible more into the money, fixed income investors may be
tempted to lock in their profit and sell the convertible, due to the expansion of the
risk premium.

25
Convertible Bonds – February 2002

In some cases, fixed income investors may not be motivated at all by upside
participation in underlying share appreciation and may only be interested in the
bond component of the convertible. In this case they will buy deep out-of-the-money
convertibles, as they will be reluctant to pay any premium to the perceived bond floor.
This type of investor may find a yield advantage in convertibles compared to their
related straight-bonds due to anomalies in the secondary market in which convertibles
are traded. Moreover the relative coupon structure and sometimes the subordination
of the convertible can differentiate it from other debt of the issuer. Often the
convertible will present a higher risk/higher reward profile than other corporate debt,
making it attractive to certain investors, under certain circumstances.

Callable asset swaps


A callable asset swap is a contract between two counterparties, which seeks to
repackage the convertible so that one counterparty owns only the fixed income
component of the convertible and the other owns just the call option on the underlying
shares. We explain below why a fixed income investor should enter into an asset
swap agreement instead of just buying a straight bond. Predictably, yield advantage
plays a key role.
In reality a ‘callable asset swap’ is not an asset swap at all, but a contract in which
the option investor physically sells the convertible to the bond investor who becomes
the beneficial owner of the security and receives the coupon payments and the
redemption value on maturity. The option investor, by retaining an option to buy back
the convertible in future, has attempted to isolate and dispose of the straight bond part
of the convertible, while retaining the right to repurchase the convertible should they
want to convert, for example.
The terms of the contract specify the cash amount due for selling the convertible
and the formula for calculating the price at which the convertible may be bought back.
The cash amount corresponds to the value of the convertible’s bond floor. This floor
is calculated at a given credit spread over Libor. The price at which the convertible
may be repurchased is worked out as another bond floor, calculated using a lower
credit spread. This lower spread, termed the ‘recall spread’, is also specified in
the contract.
The credit spread at which a fixed income investor can buy the bond element of
a convertible in a callable asset swap, may be higher than the credit spread implied
in the price of a straight-bond with the same profile. Thus, a fixed-income investor
may have the chance to buy a straight bond proxy with the same apparent level of risk,
but at an advantageous yield. We say apparently because in reality the bond investor
is short a credit option to the option investor. The value of this option is reflected
in the higher credit spread (and therefore, higher yield).

Convertibles for hedge investors


It is possible to construct a portfolio that is theoretically insulated from share price
movements. This portfolio is based on a long convertible position and a short position
in the underlying share. In order to hedge the long convertible position against changes
in the underlying share price, the number of shares that must be sold is indicated by
the convertible’s delta or ‘hedge ratio’. The number of underlying shares per bond
necessary to hedge a convertible position is given by the bond’s delta multiplied by
its conversion ratio.

26
Convertible Bonds – February 2002

Delta hedging and gamma trading


If the delta — the change in the convertible price for a one-point change in parity —
of a convertible was 40%, it would be necessary to sell a number of shares equal to
40% of the number into which the bond may be converted, to hedge it successfully.
Delta hedging insulates convertibles against small movements in the underlying
stock price. Providing the correct hedge ratio is employed, it is possible to
compensate for small share price moves on the long position in the convertible.
When the move in the underlying shares is not small, the effect of convexity
(gamma) on the convertible price cannot be ignored. For significant movements
in the underlying share, the hedged portfolio will return a positive amount regardless
of the direction of the underlying price move, all other things (including the effects
of time decay) being equal.
As the share price underlying a convertible rises, the convertible’s delta will
also rise. This causes the hedge ratio to increase meaning that more shares need to
be sold to keep the portfolio delta neutral. As the underlying share price falls, the
convertible’s delta falls and some shares must be bought back in order to re-hedge
the portfolio. The positive gamma effect ensures that hedged investors are always
buying shares after a price fall and selling after a price rise: this is one mechanism
through which hedge investors generate profits from their portfolios.
Figure 8 below uses the details of the notional John Smith Corp. Convertible EUR
4% 2007 issue, used above:

Figure 8. John Smith Corp. Convertible EUR 4% 2007 Long Convertible Position
Convertible Price €1000
Conversion Ratio 10
Underlying Share Price €80
Delta 40%
Gamma 0.5%
Source: Schroder Salomon Smith Barney Convertibles.

In order to hedge the long position of one bond against changes in the underlying
share price, we need to take a short position in four shares:
DeltaShortShareSale = ConversionRatio * Delta
DeltaShortShareSale = 10 * 40%
DeltaShortShareSale = 4 shares
When the underlying share price rises, the convertible’s delta also rises. This means
that the convertible should participate in a greater proportion of any future share
price appreciation, on an upward move in the underlying stock price, (the effect of
gamma). However, the short position in the underlying share has not been altered,
despite the convertible’s higher delta.
As a result of this, the profit on the long convertible position should be greater than
the loss suffered on the short position in the underlying stock, as the shares rise.
The net position from the trade will be a profit.

27
Convertible Bonds – February 2002

Conversely, as the underlying share price falls (causing the delta of the convertible
to fall), the bond will participate in a diminishing proportion of the decline, due to
the effect of gamma. The short position in the underlying share remains based on
the original, higher delta (40%). The loss on the convertible long position should
be smaller than the profit on the short sale of the underlying stock. Again, the net
position from the trade will be a profit.
The size of any profit on this type of trade is dependent on both the move in the
underlying stock and on the bond’s gamma profile. It is also worth considering
the following:
➤ The greater the move in the underlying share price, the greater the chance of
significant gamma trading profits.
➤ Stock volatility is a measure of the propensity of the underlying share to move
sharply. The higher the underlying stock volatility, the greater the potential
profits from the hedged convertible position.
➤ The gamma trading strategy works by adjusting the stock short necessary
(by buying back or selling shares) for changes in the share price (and therefore
delta) level. Hedged investors will be natural buyers and sellers of shares as
they maintain the portfolio hedge, according to a bond’s theoretical delta.
➤ Delta hedging is most effective when a convertible is theoretically cheap
— an investor will expect to capture more volatility than he has ‘paid for’.
Theoretical fair value depends on several variables including the assumed
volatility of the underlying shares. An investor will estimate the level of
underlying stock volatility and input this in to a convertible pricing model.
Convertibles trade at prices that can be higher or lower than theoretical fair
value, due to supply and demand. ‘Implied volatility’ is the stock volatility
that is theoretically implied in the convertible price. A convertible is defined
as ‘theoretically cheap’, if it trades below theoretical fair value and
‘theoretically rich’, if it trades above fair value.
➤ To conclude, hedge investors using this strategy to trade their convertible
portfolios, are employing a technique known as ‘gamma trading’. Gamma
trading is not infallible, however. Shares do not always exhibit sufficient
volatility for the strategy to make money. The loss of value as a result of
time decay (theta) can prove the more important factor.
Hedge funds are often highly leveraged and can produce a substantial profit for a
low initial investment. The leverage comes from their ability to create the necessary
stock short by borrowing the underlying shares at a reasonable fee. Naturally, hedge
funds will prefer convertibles with underlying shares that are both highly volatile
and easily borrowable.

28
Convertible Bonds – February 2002

Changes in the investor base over the life of the convertible


At issue, a convertible can normally be classified as one of the following:
➤ An equity alternative — a low premium and a relatively low bond floor;
➤ A yield alternative — a high premium and a relatively high bond floor; or
➤ A total return alternative — incorporating a medium premium to parity and
investment value (risk premium).
The majority of new issues will naturally fall into the third ‘balanced’ or ‘total return’
category. Such bonds typically attract a wide range of investors including mixed funds
and hedge funds. The investor base will change as the underlying share price moves
up or down, moving the convertible more in or out-of-the-money, however.
An out-of-the-money convertible is more likely to be purchased by a fixed-income
investor, who will consider selling his position to lock in a profit as the convertible
becomes more in the money. An in-the-money convertible is likely to be purchased
by an equity investor who will consider selling the bond as it begins to move
out-of-the-money and its delta starts to fall.

This chapter has explained how a convertible may be viewed from


several different angles and may fulfil differing investment objectives for
different investor bases. We have identified key valuation elements and
trading strategies including:

➤ Buying high delta convertibles as a substitute for equity;

➤ Buying high yielding convertibles as a substitute for corporate


bonds; and

➤ Buying convertibles perceived as ‘theoretically cheap’ for


hedge funds

29
Convertible Bonds – February 2002

Convertible Bonds, an Issuer’s


Perspective
➤ Convertible financing

➤ Financing objectives and prospective issuers

➤ To call or not to call?

Convertible financing
We have looked at the idea of investing in a convertible as an alternative to investing
in either equity or straight debt. We said that in general, investors would do better
investing directly in shares, when the underlying share price rises and would do
better owning straight debt, when the underlying share price falls than they would
owing a convertible. We also pointed out the limitation of this argument: at the time
of the investment, an investor cannot know whether the share price will rise or fall.
We concluded that much of the appeal of convertible securities (from an investor’s
viewpoint) is their ability to achieve high expected returns with low volatility.
In the same way, one can consider an issuer’s choice of financing using a
convertible rather than equity or straight debt.
On a share price rise If the underlying share price of a convertible were to rise above the conversion
price, investors would (eventually) convert into equity. In theory, the issuer may
have been better off economically issuing straight debt since, on conversion, the
company will in effect sell its stock at a discount to the prevailing market price.
However, one could also argue that the convertible will have proved a better form
of financing than straight equity. Assuming eventual conversion the issuer has, in
effect, made a (deferred) sale of equity at issue date. The issue price of this equity
will be at a premium to the stock price on the date of issue.
On a share price fall If the underlying share price were to fall and conversion fails to take place, the
company would theoretically have done better selling straight equity. However,
as with the investor at the time of purchase, the issuer cannot know in advance
whether the share price will rise or fall. In the weak share price scenario, a convertible
will have been a better form of financing than straight debt — if the bond is not
converted, it is equivalent to a debt issue at a lower coupon.

30
Convertible Bonds – February 2002

Financing objectives and prospective issuers


Issuing a convertible may fulfil different financing objectives:

Potential deferred sale of equity forward at a premium


The issuer of a convertible typically locks in a conditional sale price for the
underlying shares that is higher than the market price of those shares in the market,
at the time of the issue. The premium to the current share price also means that the
issuer receives greater proceeds than would be received in the case of an equity issue
(of the same number of shares), even if the equity placing were not issued at a
discount to the prevailing market price. A company that believes the market is
undervaluing its shares and expects the share price to rise, will prefer to sell equity
forward at a fairer price via a convertible than to sell shares immediately at the
current undervalued price. If the company is sure that the share price will rise, it
should issue debt to raise money, but some companies may have difficulty doing
that, such as a start-up company or a company that is already highly geared. The
issue of a convertible avoids the stigma sometimes associated with a rights issue or
other pure equity issuance. It sends a relatively positive signal to the market about
the company’s view of its own share price prospects.

Monetising equity investments


‘Exchangeable10’ structures can permit issuers to monetise stakes they hold in other
companies at attractive funding rates.

Securing low-cost funding


Any company that cannot or does not want to pay high coupons will find convertibles
a cheaper source of debt financing. Additionally, in the case of exchangeable bonds,
the issuer will retain dividend distributions on the underlying shares until conversion.
Thus the issuer will be able to fund the coupon/yield obligations partly through the
continued receipt of dividends on the underlying shares.

Tax/cash-flow advantages
Under most tax jurisdictions, only interest payments on debt are tax-deductible;
dividends are paid out of after-tax income. Thus convertible debt financing
is generally more tax efficient than equity issuance. In the case of zero coupon
convertibles, no cash interest is actually paid, but in most tax regimes the company
can deduct the interest implied by the accretion rate of the convertible, creating a
cash-flow advantage. In the case of exchangeable bonds, issuers are allowed to defer
the crystallisation of tax liabilities on the sale of shares under many tax regimes,
as the full beneficial ownership of the underlying shares transfers to the investors
only on conversion.

10
For more information on ‘exchangeables’, see page 41. They are convertible bonds issued by one company that can be converted
into the shares of a different company.

31
Convertible Bonds – February 2002

Delaying dilution
Compared with the immediate issuance of equity, the issuance of a convertible
may be beneficial for earnings per share. This is particularly true in cases where
the probability of conversion is low, as analysts will typically employ undiluted EPS
calculations. Moreover convertible investors do not have voting rights, so the issuance
of a convertible defers the dilution of voting rights in the company. Closely held
companies, for whom the issuance of voting shares may compromise control, may
have a particular interest in raising equity capital via convertibles.

Exploiting market conditions


One advantage of issuing a convertible is that it can be completed as an ‘overnight’
transaction, whereas an equity issue typically takes several weeks. Speed of
execution is a key advantage of convertible bond issuance.

Targeting a diverse and distinct investor base


The diversification of the convertible investor base enables issuers to access a
wider investment audience than they might via solely the equity market or fixed
interest market alone.
For example a company that has recently completed an equity issue may find it
easier to raise further capital via a convertible rather than returning to the equity
market. Some companies issue convertibles to widen their shareholder base and
increase visibility. A company that wishes to raise finance via a straight debt issue,
but which has a weak credit rating, might find it easier to target the convertible
investor. The convertible investor base may be more inclined to accept a greater
range of credits since much of an issue’s appeal derives from its option component.
Due to the speed with which large convertible issues are allocated and priced, and
due to the wide investor base, the size of a convertible issue can sometimes even
exceed that of equity or straight debt issue, allowing a company to maximise
issue proceeds.
The suitability of a convertible to meet to an issuer’s objectives will depend to
some extent on how it is structured. For example:
➤ A low coupon corresponds to the objective of lowering the cost of financing;
➤ A high probability of conversion corresponds to the objective of deferring the
sale of the stock at a premium; and
➤ A company wishing to keep the debt/equity ratio low will be more inclined
to issue a convertible preferred share, while those wishing to increase gearing
will be more likely to issue a convertible bond.

To call or not to call?


Often the ultimate goal of a convertible issuer is for their convertible bond to be
converted into shares. Call features allow the issuer to precipitate conversion by
sending out a call notice. The company has a dilemma when deciding whether or not
to issue a call notice, however. If parity falls under the redemption value between the
date investors are notified of the call and the call date itself, conversion is unlikely
to be forced and the company would end up redeeming the security for cash.

32
Convertible Bonds – February 2002

Companies rarely call their convertibles at the optimum moment (which will
depend on complex income and options considerations).
The decision not to call a convertible may be the result of:
➤ The uncertain course of the share price during the call period;
➤ The desire to avoid dilution; or
➤ Other balance sheet and profit and loss account considerations.

33
Convertible Bonds – February 2002

Convertible Structures
➤ Equity-linked financing

➤ Zero coupon and Original Issue Discount (OID) convertibles

➤ A plain vanilla convertible compared with a bond + warrant

➤ Convertible preferreds

➤ Mandatory convertibles

➤ DECs

➤ PERCs

➤ Exchangeables

➤ Default swaps

➤ Reset features

Equity-linked financing
Convertibles are hybrid securities with both fixed income and equity characteristics.
We have shown how convertibles can present investment opportunities for both equity
and fixed-income investors and how convertible securities can present attractive
financing opportunities for issuers. We will show here that it is possible to structure
convertible securities such that they bear a greater resemblance to an equity-alternative
instrument, or to a straight debt-alternative instrument, satisfying the demand of
investors and issuers alike.

Figure 9. The Convertible Structure Range – From Debt to Equity


Straight Zero Coupon Original Issue Plain Vanilla Convertible Mandatory Straight
Debt Convertible Discount Convertible Preferred Convertible Equity
Convertible
Source: Schroder Salomon Smith Barney Convertibles.

Zero coupon and Original Issue Discount (OID)


convertibles
In the wide range of convertible structures, Original Issue Discount (OID)
convertibles (including most 0% coupon bonds) are the closest to the straight
debt end of the spectrum.

34
Convertible Bonds – February 2002

Deferred interest payments


Zero coupon convertibles are typically issued at a deep discount to par value and are
redeemable at par. The difference between the par value and the initial issue price can
be viewed as the value of notional interest payments over the life of the convertible,
which are deferred until final redemption. The yield to maturity reflects the accretion
of the convertible price from the issue price to par.
Some OID convertibles pay a low coupon. Like zero-coupon OID’s, the remaining
value of the interest payments is reflected in the difference between the initial issue
price and the redemption price at maturity. The yield to maturity reflects the accretion
from the discount issue price to par, taking into account the value of the coupon
payments received.
A similar structure is obtained when a convertible is issued at par and redeems at a
premium. The performance of a ‘premium redemption’ structure and an OID structure
will be similar. Generally the bond floor will accrue to the redemption value. Even if
the share price is weak, the convertible price will also tend to accrete towards its
redemption value.
Figure 10. Accretion of Bond Floor and Convertible Price to Redemption Value — Zero Coupon, OID and
Premium Redemption Structures

Price

Redemption
Value

CB Price

CB Bond
Floor

Maturity
Time

Note: The course of the convertible price is affected by many factors. The graph above shows a regular rate of price accretion over time.
Source: Schroder Salomon Smith Barney Convertibles.

Put features
Zero coupon and OID convertibles often carry put options allowing the investor to
sell the convertible back to the issuer at a pre-determined price, on specified dates.
This price will typically be equal to the accreted price of the security. The accreted
price can be thought of as the issue price plus the value of unpaid notional coupons
from issue. It is normally calculated as the price at a given date, such as to give
a certain rate of return (usually the yield to maturity at issue) if held to maturity
and redeemed.

35
Convertible Bonds – February 2002

Call protection
Zero coupon and OID convertibles frequently offer investors periods of both hard
and soft call protection.

Maturity
Recent US zero coupon convertibles have had final maturities of 20-years or more.
European zero-coupon and OID issues have typically had maturities of between
five and 10-years. However, in both cases, it can be that the important date from an
investor’s perspective is the first put date. This point is illustrated most clearly when
one considers a convertible that has a put and a call at the same price and on the same
date. This date can be thought of as the effective maturity date of the bond. If it is
not in the investor’s interest to exercise the put option forcing early redemption of the
convertible, it will probably be in the issuer’s interest to force the investor to choose
between redeeming the bonds or converting them. Even if the bond does survive the
date without being put or called, it is unlikely to attract a significant premium.

Contingent features
Contingent features typically relate to restrictions on either conversion or on
interest payments: contingent conversion features and contingent interest payment
features. A contingent conversion feature limits the investor’s ability to convert.
The incorporation of such a clause in the terms of an issue is generally against the
investor’s interest. Contingent interest payment features allow the payment of a small
amount of interest to the convertible bondholder and is dependent on the average
market price of the convertible reaching a specified level.

From the investor’s perspective


Zero coupon and OID bonds are frequently more defensive instruments than coupon
convertibles because of the deep discount or premium redemption feature that they
generally possess. Figures 11 and 12 compare a notional zero coupon, premium
redemption convertible and a notional conventional convertible with the same yield
to maturity (YTM).

Figure 11. Zero Coupon Bond with Premium Redemption Structure


Issue Price 100
Coupon 0%
Redemption Value 117
Maturity 4 years
YTM 4%
Conversion Ratio 14 shares per bond
Source: Schroder Salomon Smith Barney Convertibles.

Figure 12. Plain Vanilla Convertible Structure


Issue Price 100
Coupon 4%
Redemption Value 100
Maturity 4 years
YTM 4%
Conversion Ratio 14 shares per bond
Source: Schroder Salomon Smith Barney Convertibles.

36
Convertible Bonds – February 2002

Given the same YTM, the coupon-bond has a higher probability of being converted
at maturity. If at maturity parity is 106, the coupon-bond will be converted into the
underlying shares as the redemption price of 100 is below parity. The zero coupon
bond, on the other hand, will be redeemed at 117 in this instance. In other words,
the ‘effective conversion price’, the price at which the investor is indifferent between
redemption and conversion, is much higher on the zero coupon, premium
redemption convertible than on the coupon-convertible.
Figure 13 shows the payoff of the two structures:
Figure 13. Coupon Convertible and Zero Coupon, Premium Redemption Convertible — Rate of Return
Assuming Held to Maturity

25.00%

20.00%
rate of return

15.00%

10.00%

5.00%

0.00%
100
109
118
127
136
145
154
163
172
181
190
1
10
19
28
37
46
55
64
73
82
91

parity
zero conventional

Source: Schroder Salomon Smith Barney Convertibles.

The pay-off analysis demonstrates that given the same YTM, the zero coupon,
premium redemption issue offers inferior upside participation to appreciation
in the underlying share price; the zero coupon, premium redemption structure
has a lower delta.
In practice, put features in a zero coupon bond tend to increase the value of the
bond floor, further enhancing the attraction of the structure to fixed interest investors
and reducing its equity sensitivity.

From the issuer’s perspective


Major motives for issuing zero coupon and OID bonds lie in the tax and cash-flow
advantages of the structure. Although no cash interest is actually paid, the issuer can
normally deduct the notional accretion on the convertible from taxable profits for tax
purposes. However, investors must pay taxes on the accretion. Even in circumstances
in which the tax is recoverable, the cash flow implications of this can constitute
a negative feature of zeros for certain investors.

37
Convertible Bonds – February 2002

A plain vanilla convertible compared with a bond + warrant


We have described how a convertible can be considered a combination of a straight
bond and a call option, both with the same maturity. There is however a difference
between buying a convertible and buying a ‘bond cum warrant’ issue (a bond issued
with a long maturity call option attached):
➤ A bond cum warrant package can be usually stripped into its components and
traded separately in the secondary market. A convertible is a ‘package’ and the
call is embedded in the instrument so that investors can only own the embedded
option by buying the whole instrument.
➤ Investors in a bond cum warrant can typically exercise their option by
subscribing cash instead of bonds leaving the bond portion in existence.
For a convertible, this is not the case.

Convertible preferreds
Convertible preferreds are a common structure in the US convertible market.
The instrument is a preferred stock that pays a fixed dividend (usually quarterly)
and carries rights of conversion into the issuer’s ordinary shares.
In many cases, convertible preferreds are not redeemable. The issuer is not obliged
to return any principal value back to the holder, but will have the obligation to pay
the dividend indefinitely. Owners of convertible preferreds have a lower claim on
the assets of the issuer than convertible holders, but a senior claim to ordinary shareholders.

Mandatory preferred stocks


DECs
DECs stands for ‘Dividend Enhanced Common Stock’ (or sometimes ‘Debt
Exchangeable for Common Stock’). A DECs is typically structured as a convertible
preferred share that pays a fixed quarterly dividend. The yield at issue is invariably
higher than the current yield of the underlying common stock. A DECs will
automatically convert into the underlying ordinary shares of the issuer at maturity;
in some cases a DECs can also be converted prior to maturity.
As with a traditional convertible security, the coupon and premium are set at issue.
The term ‘conversion premium’ has a different meaning for a DECs, however.
The conversion terms (ie conversion ratio) of a DECs vary according to the level of
the underlying share price at the date of conversion. The ‘true’ premium is a moving
target. By convention, the premium quoted is that based on the lowest conversion
ratio (or highest conversion price) that could apply. DECs typically have a maturity
of three to four years.
Adjusted conversion The number of shares received upon conversion depends on the price of the
ratio underlying shares at maturity or in cases where early conversion is possible,
at the time of conversion. The minimum conversion price is normally the share
price at issue and the maximum conversion price is typically some 25% higher.
The issue price of a DECs is sometimes the price of the share at issue though
many now have an issue price of US$50, however. For simplicity, the example
below assumes the issue price is the share price at issue.

38
Convertible Bonds – February 2002

The conversion price will be set according to the following rule:


➤ When the underlying share price is at or below the share price at issue,
the conversion ratio is 1:1; one preferred share is convertible into one
ordinary share.
➤ As the share price moves between the price at issue and the maximum conversion
price, the conversion ratio is adjusted downwards and a preferred share becomes
convertible into less than one ordinary share. The ratio is set such that the value
of the shares delivered on conversion equals the share price at issue.
➤ Above the maximum conversion price, the conversion ratio no longer falls and
is fixed at the minimum level set at issuance. The figure quoted for premium
at issue is based on this conversion ratio.
This rule is summarised in Figure 14.

Figure 14. Conversion Ratio and Value of Share Received on a DECs Issued at Share Price at Issue
Stock Price Number of Shares Received Value of the Shares Received
Stock Price < Issue Price 1 Stock Price at conversion
Issue Price < Stock Price < Conversion Price Issue Price/ Current Stock Price Issue Price
Stock Price > Conversion Price Minimum Conversion Ratio Conversion Ratio * Stock Price
(issue price/maximum conversion price) at conversion
Source: Schroder Salomon Smith Barney Convertibles.

Where the issue price of the DECs is US$50 rather than the share price at issue,
the conversion ratio calculated needs to be multiplied by a factor given by the ratio
of 50 to the share price at issue. For example if the share price at issue is US$25,
the applicable conversion ratio will be twice that in the table above.
Total return analysis Figure 15. Total Return Analysis on a DECs

Equity
Total
Return
DECs

Dividend Advantage

Straight-Debt

Cap

Issue Price Max Conversion


Com m on Share Price
Price

Source: Schroder Salomon Smith Barney Convertibles.

The post facto performance characteristics of a DECs are as follows:

39
Convertible Bonds – February 2002

Below the issue price:

➤ Conversion ratio = 1:1;


➤ Equity participation = 100%;
➤ The DECs outperforms the underlying share due to its yield advantage.

Between the issue price and the maximum conversion price:

➤ The conversion ratio decreases towards the minimum;


➤ No equity participation;
➤ The total return of the DECs can still exceed that of the share due to the
dividend advantage

Above the maximum conversion price:

➤ Conversion ratio set to minimum;


➤ The DECs underperforms the underlying common stock;
➤ There is positive upside participation.
Many investors perceive a DECs as a form of ordinary share where an element of
equity participation is sacrificed in exchange for a higher yield. A DECs is usually
non-callable for life.

PERCs
PERCs (Preferred Equity Redemption Cumulative Stock) are typically structured
as mandatory preferred convertibles with a maturity of three to four years.
Adjusted conversion The number of shares received upon conversion depends on the underlying share
ratio price at conversion relative to the ‘cap level’ set at issue. A PERCs structure offsets
a higher yield against lower upside participation. As the underlying share price
rises above a pre-set cap level, a PERCs becomes convertible into fewer and fewer
underlying shares, keeping the total return payoff constant. The conversion ratio
is calculated as:

Figure 16. Conversion Ratio on a PERCs


Stock Price Shares of Common Stock Received
Stock price > Cap Price Cap Price / Stock Price at Conversion
Stock Price < Cap Price 1
Source: Schroder Salomon Smith Barney Convertibles.

➤ Under the cap level, one preferred share is convertible into one underlying share
so that the equity participation is 100%.
➤ Above the cap level, the conversion ratio is below 1:1. One preferred share
is convertible into less than one share of the underlying, so that the equity
participation is limited.

40
Convertible Bonds – February 2002

Figure 17. Payoff Analysis for a PERCs

Equity
Total
Return

Cap
Dividend Advantage
PER Cs

Straight-Debt

C ap Level
C om m on Share Price

Source: please add source.

Payoff analysis Under the cap level:

PERCs outperform the underlying common stocks due to the dividend advantage.

Above the cap level:

The total return of the PERCs is kept constant. The PERCs no longer has sensitivity
to the rising share price, so above a certain level the share will deliver a superior
return, in spite of the PERCs’ dividend advantage.

Exchangeables
Exchangeables are bonds issued by one company that exchange into the shares of a
different company. They can be issued in both mandatory and non-mandatory form.

From the issuer’s perspective


Exchangeable bonds can permit a company to dispose of or monetise a shareholding
in another company, regarded as a non-core asset. Not surprisingly, the justification
for issuance bears a strong resemblance to that for any convertible. If the issue
remains unconverted, the issuer will have secured low cost funding. If it ends up
being converted, the issuer will have succeeded in disposing of the non-core stake
at a premium to the price that ruled at the time of issue. In many tax jurisdictions
the disposal of a stake by means of an exchangeable bond enables the issuer to defer
the crystallisation of tax liabilities on the sale.
Governments have also considered exchangeables as an effective way of monetising
shareholdings as part of privatisation programmes. The appeal is not only the ability
to manage privatisations when equity markets are unreceptive, but also to lock in
low cost efficient funding.

41
Convertible Bonds – February 2002

From an investor’s perspective


Exchangeable bonds have potential credit advantages and disadvantages for the
investor. The dislocation of credit risk and underlying share price performance risk can
be a potential benefit for the holder of the exchangeable, though could also potentially
lead to a doubling of credit and performance risk, given the dual exposures.

Default swaps
As with any other bond, the investor has exposure to the default risk of the issuer.
To gain protection, a convertible investor may enter into a default swap.
In a default swap, the credit seller pays a premium quoted as a fixed interest rate
(in basis points), usually every three months, on the principal amount of the swap
(the total nominal being hedged). The counterparty to the transaction assumes the
risk of default. They will make a single contingent payment to the investor if the
issuer of the security defaults.
A default swap contract usually specifies what constitutes a default event. These will
normally include events such as:
➤ Bankruptcy;
➤ Failure to pay;
➤ Obligation acceleration/default;
➤ Repudiation/moratorium; and
➤ Restructuring of the debt.
Increasingly in modern default swap contracts, the single contingent payment in
the event of default is replaced by the payment of the principal amount against the
delivery of the bond itself.

Reset features
A convertible in which the terms of conversion are subject to adjustment based
on the behaviour of the price of the underlying share is termed a reset convertible,
though reset clauses can be included in the terms and conditions of many convertible
structures. Reset features allow for a change to the conversion price of a convertible
in the event of share price depreciation (downward reset) or appreciation (upward
reset) on a certain pre-specified date or dates.
Downward reset clauses allow for an increase of the conversion ratio in the event that
the underlying share price is below the initial conversion price on (or shortly before)
the specified reset dates: the investor will be given more shares on conversion as their
value has declined. The new conversion price is typically based on the average share
price level over a specified period shortly before the reset date. In most cases the
average is adopted as the new conversion price. Disregarding movements in the share
price between the averaging period and the reset date, and assuming the average is not
below the minimum conversion price discussed below, parity is set at 100%.

42
Convertible Bonds – February 2002

A reset clause specifies a reset floor, which is the minimum level to which the
conversion price may be reset: even if the average share price goes below this level,
the adjustment of the conversion price will be limited by this floor.
Sometimes there is also the possibility of an upward reset of the conversion price
in the event that the underlying share price is above the ruling conversion price on
(or shortly before) specified reset dates: an investor will be given fewer shares on
conversion as they have appreciated in value. Such structures are unusual, however.
Generally, even for bonds where the conversion price can be reset up or down, the
level of the conversion price set at issue will be the cap for an upward reset.
These features are interesting for their implications on delta and gamma. In the
proximity of the reset floor, the expected number of shares that will be delivered
on mandatory conversion rises; (mandatory reset convertibles were popular in
Japan during the 1990s particularly). Share price falls increase the theoretical hedge
necessary to remain delta neutral; (the number of shares a resettable convertible
security can be exchanged for increases as the share price falls).
In effect, delta on a resettable convertible security rises as the underlying share
price falls below the minimum reset level and therefore gamma will be negative.
This feature can create substantial pressure on the share price as arbitrageurs continue
to sell shares to cover their increasing exposure (increasing delta) to the underlying
share price, accelerating the share price decline in the process. Arbitrageurs capture
volatility by selling shares as the share price rises and buying shares as the share price
falls: they are ‘long’ volatility. When the share price is close to the reset floor, the reset
feature mechanism will make them do the opposite, selling stocks as the share price
falls: so they will be ‘short’ volatility.
The DECs structure mentioned above falls under the general heading of a reset
convertible. It is a mandatory reset convertible with one reset at maturity.

43
Convertible Bonds – February 2002

Pitfalls and Protection


➤ The prospectus

➤ Convertible pitfalls and protection

The prospectus
As convertible investors do not physically own the shares into which they have
rights of conversion, they rely on the terms and conditions outlined in the bond’s
Prospectus and Trust Deed (or Indenture) for protection. These include many
covenants regarded as standard in the terms and conditions of straight bonds,
which prevent the issuers undertaking certain courses of action which are detrimental
to the interests of bondholders. Convertibles are vulnerable to certain actions
over and above those of straight bonds, however. These fall into two general categories:
1 Events that would tend to lower the fair premium of the convertible. One example
of this would be a takeover for cash that leaves the bondholder with rights of
conversion into cash, or near cash.
2 Events, such as rights issues, that tend to have a dilutive effect on the underlying
share price.
These matters are dealt with in more detail below.
The prospectus will also provide information on the dividend and coupon
entitlements of a convertible bond.

Convertible pitfalls and protection


Special distributions to shareholders
Distributions that cause the underlying share price to fall (on announcement
or ex-date) reduce the value of the convertible, unless there is some form of
compensation to convertible holders. The convertible price reduction will be
approximately equal to the amount of the distribution expressed in parity terms
multiplied by the delta of the convertible. The sensitivity of the value of the
convertible to common dividends is well known, and convertible models will
give a lower fair value for the convertible, the higher the dividend assumptions.
Unanticipated capital distributions such as special dividends however, will put
convertible bondholders that are not protected by anti-dilution provisions,
in a situation that is unfavourable and unexpected. In some cases, convertible
bondholders may be forced into early conversion in order to participate in
the distribution.
Most modern convertible prospectuses contain language designed to protect holders
against capital distributions. However, the definition of a capital distribution can
vary in its generosity. Some prospectuses define a capital distribution as one that
pushes the annual yield on the underlying shares above a specified level. Whether
this yield is set in relation to the previous year’s dividend or some absolute level,
investors generally regard these clauses as acceptable.

44
Convertible Bonds – February 2002

In some prospectuses, only distributions that exceed net earnings since the issue
of the convertible count as a special distribution. In these cases, there is generally
more scope for disadvantgeous treatment of the convertible bondholder.

Anti-dilution provisions
Anti-dilution provisions cover a range of situations that can result in dilution
of the underlying share price (and therefore the number of shares underlying the
convertible). The provisions will stipulate the situations in which convertible holders
are compensated for a dilutive event by receiving an improvement in the conversion
terms, and the formula for any such adjustment. The intention is generally to increase
the conversion ratio such that parity (that is the equity value of the convertible)
is left unchanged, after accounting for the fall in the share price resulting from
the dilutive event.

Stock-split
Conversion ratios are almost always adjusted in case of the most straightforward
of dilutive events, the stock-split. If the stock-split were on a one-for-one basis
for example, the conversion ratio would be doubled.

Merger or takeover
In the case of a merger or takeover of the issuing company by another company,
the treatment of the convertible bondholder will depend on the conditions of the
prospectus or trust deed. In some cases there is no protection.
In general, where there are provisions for a merger or takeover event, there is a
distinction in treatment of a bid (mainly) for cash and one that is (mainly) for shares.
In an all-share bid by a quoted company, it is generally considered reasonable for
the rights of conversion to be transferred into the shares of the new entity on a basis
equivalent to the terms of the deal (the ‘see through’ basis). The bidder would also
assume responsibility for the coupons and repayment of the convertible, if necessary.
There is no presumption as to whether such a turn of events will be advantageous
for convertible holders. It will depend, inter alia, on the volatility of the new company
relative to that of the old, the dividend policies of the new company and its
credit status.
The danger in the event of a cash bid is that the exchange property of the convertible
becomes cash. In this situation, the lack of potential movement in the exchange
property would extinguish the premium. A number of devices can be applied to
address this situation. In some convertibles there is a ‘ratchet’ mechanism in which
the conversion ratio is adjusted by a specified amount if the takeover takes place
within a given time frame. In others there is an adjustment to the conversion ratio,
which is based on the average premium of the convertible over a specified time
period. Sometimes the takeover language also includes an investors put at par,
accreted price, or some other value.

Income entitlement
In the European convertible market, a measure of standardisation now exists on the
question of dividend entitlement. The general rule is that accrued interest is not paid
on a convertible on conversion and the shares delivered on conversion will rank pari
passu with existing shares. There are, however, a number of exceptions to this rule.

45
Convertible Bonds – February 2002

In particular, if holders are ‘forced’ to convert by the sending out of a call notice,
there is often language giving protection against the ‘unfair’ scenario in which
a long period has passed since a convertible coupon has been paid yet converting
bondholders have just missed a dividend payment. Some transactions specify
dividend entitlement that amount to delivery of ordinary shares that are ineligible
for one or more dividends. For example, the entitlement to dividends may be
based on the financial year in which conversion takes place.

Clean-up calls
If a certain percentage of the bond has already been converted into shares, the issuer
may be entitled to call any remaining bonds thus forcing conversion. The percentage
will be often set at around 90% of the convertible issue size.

46
Convertible Bonds – February 2002

Convertible Pricing Models


➤ Recursive techniques

➤ Approximations using European options

Recursive techniques
Most convertible pricing models are based on the binomial tree approach.
This employs a recursive procedure in a manner similar to that employed in valuing
American options. This approach can deal with most of the common features found
in convertibles — it can capture not only the value of the early conversion right,
but also calls, puts and other characteristics. The major limitation of the binomial tree
approach is that it allows the share price to follow a stochastic path, but treats all other
inputs, such as bond yields, dividends and FX rates as being either predetermined or
dependant on the share price. Of these, the lack of a random element in the interest
rate assumption is particularly significant limitation. Additionally, if bonds and
equities are positively correlated, the technique will tend to overstate the value of
the convertible.
Models have been developed to allow more variables to be modelled incorporating
stochastic bond yields and bond yields that are correlated to equity prices.
Generally they employ recursive procedures similar to those of simple binomial
trees. The number of factors in a model refers to how many variables are modelled.
A one-factor model varies just underlying stock prices, whereas a two-factor model
takes account of movements in interest rates as well.
The major disadvantage of a two-factor model is its complicated nature and lack
of transparency. In a one-factor model, it is necessary to input the following:
➤ An assumption of the Libor spread (or spread to Treasuries; the credit
spread assumption);
➤ Dividends on the underlying share until maturity; and
➤ A volatility assumption for the underlying stock.
With a two-factor model the number of assumptions increases. An investor may
have a feel for the volatility assumptions they wish to employ for a share, but would
have no intuition as to the appropriate bond volatility and correlation.

Building a binomial tree


As with other options models, binomial trees deal with probabilities. It is easy
to misunderstand the nature of these probabilities, however. They do not relate
to the chance of certain events occurring in the real world, but are set such that the
expected price of the share at any given date is constrained to equal the theoretical
forward price at that date. These ‘shadow’ probabilities are referred to as ‘risk
neutral probabilities’. The forward price is based on arbitrage considerations and
driven by interest rates and dividend assumptions, rather than expectations.

47
Convertible Bonds – February 2002

The tree works by dividing the life of the bond into specific moments in time, with
a range of convertible prices considered for each. Apart form the final (maturity date)
range each price is calculated from two prices from the chronologically succeeding
range. The relationship between the price and the two prices from which it is
composed being given by the volatility of the share and a drift factor.
One starts by associating a value for the convertible with each share price level at
the maturity date of the bond. In general, for share price levels above the conversion
price the value is parity and for share price levels below the conversion price it is
100%. One now simply works backward through the tree. The next stage will be one
period nearer the present day, with the period length being determined by the term
of the convertible and the number of steps chosen. A new distribution for this stage
is established and a value is assigned to a range of outcomes. In some cases the value
for the convertible associated with each node calculated in this manner will need to
be replaced if some feature of the bond makes this appropriate. For example if the
bond is puttable at 100 on a certain date, then all observations under 100 at this
date will simply be replaced with 100.
This process continues until one arrives at the present day with a fair value for
the bond.
Formulae for the share price outcomes at maturity, the probability of an up, the
probability of a down and the drift rate per period are based on simple algebra
and can be found in options text books.

Approximations using European options


From an equity We have established that the value of a convertible to an equity investor can be
investor’s perspective summarised as:
Convertible Pr ice = Parity + PutOptionValue + ValueofIncomeAdvantage
In simple, non-callable convertibles we can thus calculate the theoretical value
by establishing valuations for the components:
➤ Parity is simply the conversion ratio multiplied by the current stock price
expressed in the bond currency.
➤ The put option value can be calculated using the Black Scholes model
(the derivative pricing model based on the binomial tree approach). The put is
interpreted as the right to sell a parity number of shares at the redemption price.
Thus the model is set for a plain vanilla European put exercisable only at maturity.
If the adopted horizon is some other date, crude adjustments to estimate the
value of the put will be necessary.
➤ The income advantage value is calculated as the present value of the
income advantage.

48
Convertible Bonds – February 2002

By adopting this approach, an equity investor can obtain a very clear impression
of what they are paying for when they buy a convertible at a premium. However,
the approach fails when there is a good chance of voluntary early conversion or
when there is a period in which the bond is callable. When the call is provisional,
even approximations in which the first call date is treated as the effective horizon
are unreliable.
From a fixed income We showed that the value of a convertible to a fixed income investor can be
investor’s perspective summarised as:
Convertible Pr ice = BondFloor + CallOptionValue
We can find the theoretical value of a non-callable convertible by calculating the
values of its components:
➤ The bond floor value is calculated as the present value of the future coupon
payments and the cash redemption value, discounted at the relevant Libor spread
plus a credit spread.
➤ The call option value can be calculated using the Black Scholes model set for
a vanilla European call, exercisable at maturity.
Again the major advantage of this approach is its transparency for investors.
The problem is that the approach is only theoretically correct if the bond happens to
be non-convertible and non-callable for life. The extent of the potential error depends
on how different the terms of the convertible in question are to this basic description.
If the bond is convertible at any time, the approach is deficient in that it ascribes
zero value to the early exercise option. However where there is a significant income
advantage in the convertible, the early exercise right is of little or no value anyway.
In the case of callable bonds, an adjustment is necessary to approximate for the impact
of this feature. If the bond is callable, an adjustment to the effective strike price,
based on the forward bond floor, is available. Where there is a provisional call period,
however, the application of the European option methodology breaks down.

49
Convertible Bonds – February 2002

Appendix

Introduction
This appendix contains additional information on the following subjects referred
to previously: yield to maturity (YTM), bond floor, delta, gamma, vega, rho, theta,
and fugit.

Yield to maturity (YTM)


YTM can only be calculated through a process of iteration. The formula below
shows the relationship between the bond price, the (annual) YTM, the coupon and
the redemption amount in a simplified case where there is an exact number of years
until maturity and the bond and coupons are paid annually.
m
C R
Convertible Pr ice = å +
i =1 (1 + YTM ) (1 + YTM )m
i

Where:
m = years to maturity;
C = coupon; and
R = redemption value.
In the case of the John Smith Corp Convertible EUR 4% 2007, the YTM of the issue
is that which solves the equation:
5
€ 40 € 1,000
€ 1,000 = å + = 4%
i =1 (1 + YTM ) (1 + YTM )5
i

Bond floor
One formula that can be used to calculate a convertible’s bond floor bears a strong
resemblance to the YTM formula above.
m
C R
ConvertibleBondFloor = å +
i =1 (1 + d ) (1 + d )m
i

Where:
m = years to maturity;
C = coupon;
R = redemption value
d = discount rate (the risk free rate (m) + a credit spread)
The formula applies where there is a whole number of years to maturity. A somewhat
more complex formulation is required when there are fractional periods, though the
principal of finding the discounted present value of the fixed payments is the same.
When there are fractional periods, the value is ‘dirty’. In order to quote it, we need
to deduct the accrued interest and to express the result as a percentage of par.

50
Convertible Bonds – February 2002

The discount rate is calculated using the risk-free rate for the maturity of the bond,
plus a credit spread that reflects the credit quality of the issuer. In Europe, it is
common to adopt the swap rate (Libor) in the currency in which the convertible
is denominated as the risk-free rate. It is necessary to make an assumption on
the credit quality of the issuer.
If the euro-Libor rate (the risk-free rate) for the five-year, euro-denominated John
Smith Corp convertible is 5.423% and appropriate credit spread for John Smith Corp
is 100bp, the appropriate discount rate for the John Smith Corp Convertible EUR 4%
2007 is 6.423%.
Solving for the bond floor on the John Smith Corp Convertible EUR 4% 2007 at
issue gives:
5
€ 40 € 1,000
ConvertibleBondFloor = å + = € 899.098
i =1 (1 + 0.6423) (1 + 0.06423)5
i

Expressed as a percentage of par, this is 89.91% (€899.1/€1,000).


Another method calculates the spot yield curve and discounts each future payment
using the appropriate spot rate plus the credit spread.

Delta
Figure 18 displays the sensitivity of the price of the convertible to changes in parity.
It shows that in geometric terms, delta is the slope of the tangent drawn on the
convertible price curve at the level of the current share price (parity).
Figure 18. Convertible Price against Parity

CB1

CB0
Convertible

P0 P1
Parity

Source: Schroder Salomon Smith Barney.

51
Convertible Bonds – February 2002

Figure 18 shows how the tangent can be an accurate representation of convertible


price movements only for small share price movements.
If parity moves from P0 to P1, then
(P1 − P0) * Delta ≈ CB1 − CB0
If we consider infinitesimal changes, d, then
d ( Parity ) * Delta = d (Convertible Pr ice)
d (Convertible Pr ice)
Delta =
d ( Parity )
Figure 19. Delta against Parity

Delta

100

90

80

70

60

50

40

30

20

10

0
Parity

Source: Schroder Salomon Smith Barney.

Gamma
Gamma is the rate of change of delta for movements in the underlying share price:
d ( Delta)
Gamma =
d ( Parity )
Conventionally, gamma is expressed as the change in delta for a one-unit increase
in parity.
We can interpret:
➤ Delta as the first partial derivative of the convertible price curve with respect to
parity; it measures the slope of the tangent drawn on the convertible price curve
at the current level of parity.
➤ Gamma as the second partial derivative of the convertible price curve with
respect to parity; it measures the degree of convexity of the convertible price
curve at the current level of parity.

52
Convertible Bonds – February 2002

d ( Delta)
Gamma =
d ( Parity )
d 2 (Convertible Pr ice)
Gamma =
d ( Parity 2 )
We can isolate an approximate formula to estimate the change in the price of a
convertible for a given absolute change in parity:

Convertible Pr iceMove = Delta * ParityMove + 1 Gamma * ParityMove 2


2
This is a simple approximation by linear interpolation; if the initial delta is D1, the
final delta is approximately D2:
D2 = (D1 + Gamma * ParityMove)
So the average delta over the whole move is:
D1 + D2
DA =
2
D + (D1 + Gamma * ParityMove)
DA = 1
2
Gamma
D A = D1 + * ParityMove
2
The formula above shows the convertible price move is the average delta multiplied
by the parity move:

æ Gamma ö
ParityMove*ç D1 + * ParityMove÷ = Delta* ParityMove+ 1 Gamma* ParityMove2
è 2 ø 2

It can also be derived from a simple Taylor series expansion.


For small stock price fluctuations, delta multiplied by the parity move can be a
good approximation for changes in the convertible price. Adjusting for the effect
of gamma is particularly important for larger share price movements, as the effect
of convexity on the convertible price can be significant.

53
Convertible Bonds – February 2002

Figure 20. Gamma against Parity

Gamma

1.2

0.8

0.6

0.4

0.2

0
Parity

Source: Schroder Salomon Smith Barney.

Gamma changes along the convertible price curve. Gamma is always positive in
conventional convertibles (as delta increases for increases in parity), and it is at
a maximum when the convertible is close to, or at-the-money.

Vega
Vega is the sensitivity of the convertible price to changes in the volatility of the
underlying stock. It can be expressed as follows:
d (Convertible Pr ice)
Vega =
d ( StockVolatility )
Figure 21. Vega against Parity

Vega

0.45

0.4

0.35

0.3

0.25

0.2

0.15

0.1

0.05

0
Parity

Source: Schroder Salomon Smith Barney.

54
Convertible Bonds – February 2002

As can be seen from Figure 21, vega is always positive on a standard convertible and
is greatest when the convertible is close to, or at-the-money. A change in the stock
volatility assumption may not have a material impact on fair value if the convertible
is out-of-the-money or deep in-the-money.

Rho
Rho measures the sensitivity of the convertible price to movements in interest rates.
Rho can be expressed as follows:

d (Convertible Pr ice)
Rho =
d ( InterestRate)

Figure 22. Rho against Parity

Rho

0.9

0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0
Parity

Source: Schroder Salomon Smith Barney.

Rho is always a negative number in conventional convertibles, as an increase in


interest rates has a greater negative impact on the value of the bond floor, than it
does a positive impact on the value of the embedded call option. As the bond floor
becomes the most important component of a convertible’s valuation (the convertible
is out-of-the-money), the sensitivity of the convertible price to changes in interest
rates increases.

Theta
Theta is the change in convertible price with the passage of time. Conventionally,
it is expressed as the percentage change in the convertible price for the passage
of one day, all other things being equal.
d (Convertible Pr ice)
Theta =
d (Time)

55
Convertible Bonds – February 2002

As a convertible approaches final maturity, we see two opposite effects on the


convertible price:
➤ The value of the embedded call option decreases and so the convertible price
decreases; and
➤ The bond floor trends towards the redemption value over time. Convertibles
trading below redemption value will rise towards this value over time.
At-the-money convertibles will usually suffer from the first of these effects, with theta
being a negative number. Out-of-the-money convertibles (including original issue
discount bonds, for which the effective strike price is considerably in excess of the
share price), the drag to redemption of the bond element can be the more potent force.
Figure 23 shows the effect of the passage of time on a notional four-year convertible.
For the line marked ATM, parity is 100 throughout, and the line marked OOM parity
is 80 throughout. The notional bonds both have 1% coupons in a 5% interest rate
environment, so there is a natural upward drift in the bond floor in both cases.
Figure 23. Time Decay for At-The-Money and Out-Of-The-Money Convertibles

108

106

104

102

100
value

98

96

94

92

90
2

8
0

4
0.

0.

0.

0.

1.

1.

1.

1.

2.

2.

2.

2.

3.

3.

3.

3.

time
ATM OOM

Source: Schroder Salomon Smith Barney.

56
Convertible Bonds – February 2002

Glossary
Accreted value The accreted value is the price at which an OID or premium redemption bond yields
the same as it did when it was issued. If, for example, a 10-year zero-coupon bond
were issued at a price of 50 to yield 7.2%, after five years the accreted value would
be 70.7. At that price the bond would yield 7.2% to maturity at 100 after a further
five years.
Accrued interest This is the value of the accrued portion of the coupon on a convertible bond.
Generally, it is the coupon amount divided by the number of days in a year,
multiplied by the number of days since the last coupon was paid. To calculate
accrued interest accurately, the bond’s method of accrual needs to be known.
Different methods predominate in different markets.
American-style option This type of option allows the holder to exercise into the underlying asset at any
time during the life of the option.
Anti-dilution provisions These provide for an adjustment in the conversion terms in the event of special
stock dividends, stock splits or other corporate events that can result in the dilution
of the underlying share price.
At-the-money A convertible is said to be at-the-money if the current share price is close to the
conversion price.
Balanced convertible A balanced convertible is a convertible that trades at a price where it is neither a
pure equity substitute nor trading on its bond floor, but is balanced between the two.
Binomial tree A binomial tree option-pricing model estimates the theoretical value for an option.
Adaptations of the approach are commonly applied to convertible bonds. They take
account of events such as puts and calls that take place during the life of the instrument.
Black-Scholes option- The option-pricing model derived by Fischer Black and Myron Scholes is used
pricing model to estimate the theoretical fair value of option contracts based on a range of inputs
and assumptions.
Bond floor (or The bond floor is the value of the straight fixed income element of the convertible
investment value) if rights of conversion are ignored. The bond floor should support the price of a
convertible if the underlying equity falls, thereby allowing holders of the bond
to outperform holders of the equity.
Bond with/cum warrant This is a straight bond issued with a long maturity call option attached. The bond
cum warrant can be stripped and traded separately in the secondary market.
Breakeven The breakeven calculation for a convertible measures the time taken for the bond’s
income or yield advantage to offset the cost to the investor of a bond’s conversion
premium. It is a simple measure that takes no account of dividend growth
projections or discounting for present value.
Call feature A call feature gives a convertible issuer the right to redeem a convertible bond prior
(or call option) to maturity at a price determined at issue. Holders of convertibles who receive a call
notice will generally have time to exercise their rights of conversion before repayment
takes place; thus a call option can frequently be interpreted as required early conversion.

57
Convertible Bonds – February 2002

Clean price The clean price is the price of a convertible bond quoted without accrued interest
included. Most convertibles are quoted this way.
Clean-up call When an issuer is entitled to call any remaining bonds if a certain percentage of
the bond issue has already been converted into shares, it is termed a ‘clean-up call’.
The percentage is often set at around 90% of the convertible issue size.
Contingent conversion A contingent conversion feature makes a convertible investor’s ability to convert
contingent upon some factor such as the share price attaining a specified level.
Contingent interest Contingent interest payment features allow the payment of a small amount of
payment interest to the convertible bondholder if the average market price of the convertible
falls to a specified level.
Conversion premium See premium.
Conversion price At issue, the conversion price is the price at which shares are effectively ‘bought’
upon conversion, if the convertible is purchased at the issue price. It is calculated
by dividing the issue price of the bond by the conversion ratio.
Conversion ratio The conversion ratio is the number of shares into which each bond can be converted.
Convertible preferreds These are preferred shares issued by a company that are convertible at the option of
the investor into the common shares of that company. They pay a fixed dividend and
are often issued in perpetual form so therefore may not be redeemable.
Convertible price This is the price at which the convertible is traded in the market. It is generally
quoted as a percentage of par (the face value of the bond).
Coupon The coupon is the interest payment per bond. It is normally quoted as a percentage
of the face value.
Credit spread The credit spread is the spread over the swaps curve (or sometimes Government
bond curve) at which the issuer is assumed able to issue a straight bond that is
otherwise identical to the convertible.
Cross currency A convertible that is denominated in a different currency to that of the
convertible underlying shares.
Current (or running) Current yield is the income per unit of currency invested. It is calculated by dividing
yield the coupon by the current convertible price.
DECs DECS stands for Dividend Enhanced Convertible Securities or Debt Exchangeable
for Common Stock. DECs are mandatory convertibles, typically issued as preferred
stock paying quarterly fixed dividends.
Delta Delta is a measure of the sensitivity of the convertible bond price to share price
movements. It is defined as the expected change in the convertible price for a small
absolute change in parity.
Denomination This is the minimum size in which the bond can be traded.
Dirty price The dirty price is the clean price of a convertible bond plus its accrued interest.
It is the actual price an investor will pay for a bond.

58
Convertible Bonds – February 2002

Dividend yield The dividend yield is an indication of the income generated by each share.
It is calculated by dividing the annual dividend per share by the share price.
European option This type of option gives the holder the right to exercise an option only on the
maturity date.
Exchangeable bond This is a convertible bond issued by one company that can be converted into
the shares of a different company.
Gamma Gamma measures the sensitivity of the convertible bond’s delta to share price
movements. It is the change in delta for a one-point change in parity.
Greenshoe The Greenshoe is an over-allotment option that allows an underwriter to increase
the number of bonds issued, typically by 10%-15%, when there is strong demand
for an initial offering.
Hard call protection A period of time specified in the indenture of a bond during which the issuer
is not allowed to call the bond from the investor under any circumstances.
Hedge ratio A convertible bond’s hedge ratio is also referred to as ‘delta’. The hedge ratio
shows the equity sensitivity of a convertible bond and enables an investor to
calculate how many shares they would need to sell to hedge their equity exposure.
High-yield convertible If the share price falls dramatically, leaving the convertible so deeply out-of-the-
money that its equity component becomes immaterial, it is sometimes referred
to as a high-yield convertible. Issues for sub-investment grade companies are
also referred to as high-yield convertibles.
Implied volatility Implied volatility is the convertible pricing model volatility input used that brings
the fair value of a convertible into line with its market price.
In-the-money A convertible is said to be in-the-money if the current share price is greater than
the conversion price.
Issue price The issue price is the price at which convertible bonds are sold to investors at issue.
Mandatory convertible This is a convertible in which the bondholder is obliged to convert into the
underlying equity at maturity.
Maturity The maturity date is the final redemption date of the bond.
Nominal value This is the face value of the bond. It is often 1,000 of the relevant currency in
the Euroconvertible market and ¥1,000,000 in the Japanese and Euroyen markets.
The current price, issue price and redemption price of most convertibles are expressed
as a percentage of the nominal value.
Original issue A convertible issued at a discount to par is termed an original issue discount convertible.
discount (OID)
Out-of-the-money A convertible is said to be out-of-the-money if the current share price is below the
conversion price.
Par Par is the face value of a bond.
Par put convertible A convertible in which the investor has a put option prior to final maturity at par.

59
Convertible Bonds – February 2002

Parity Parity is the market value of the shares into which the bond may be converted.
It is calculated by multiplying the conversion ratio by the current share price expressed
in bond currency terms. It is normally expressed as a percentage of a bond’s
nominal value.
PERCs PERCs stands for Preferred Equity Redemption Cumulative Stock. PERCs are
a mandatory convertible bond structure that caps upside participation in a
stock’s performance.
Premium A convertible’s premium is the percentage by which the market price of the
convertible bond exceeds parity. It represents the extra cost an investor must pay to
buy the shares a bond converts into via a convertible. It is calculated by subtracting
parity from the convertible price and is expressed as a percentage of parity.
Premium put convertible A convertible in which the investor has a put option prior to final maturity with a put
price above par.
Premium redemption This describes a convertible bond that is issued at par but redeems at a premium
structure to par.
Put feature A put gives investors the option to sell back the convertible bond to the issuer at
a fixed price on a given date or dates.
Ratchet In some convertibles there is a ratchet mechanism in which the conversion ratio is
adjusted by a specified amount if a takeover takes place within a given time frame.
Redemption price The redemption price is the price at which the issuer must redeem bonds at maturity.
Reset date The date on which a change of conversion terms takes place on a reset convertible is
termed the reset date.
Reset features Reset features allow for a change in the conversion price of a convertible in the
event of share price depreciation (downward reset) or appreciation (upward reset)
on certain specified dates.
Reset floor The limit below which the conversion price on a reset convertible cannot fall.
Reset period In most reset convertibles, the share price upon which the new conversion price is
based is calculated by reference to the average share price observed in a specified
reset period.
Rho Rho measures the sensitivity of the convertible price to movements in interest rates.
It is expressed as the change in the convertible price for a one basis point move in
interest rates (a parallel shift in the yield curve).
Risk premium The risk premium is the difference between the convertible price and the bond floor
expressed as a percentage of the bond floor.
Soft call This is a period of time during which the issuer may only call the bond if the share
(or provisional call) price has traded above a predetermined premium to the conversion price for a set
period of time. This predetermined premium is known as the call trigger. The call
trigger is often stated as a percentage of the conversion price; thus ‘subject to
a 140% trigger’ means that the call trigger is 140% of the conversion price.

60
Convertible Bonds – February 2002

Step-up coupon This is where the coupon level increases at a future date. This can be a contingent
event on for instance, a credit rating downgrade.
Theta Theta is the change in the convertible price with the passage of time. It is expressed
as the change in the convertible price for the passing of one day, other things
being equal.
Vega Vega is the sensitivity of the convertible price to changes in the volatility of the
underlying stock. Vega is the change in the fair value of the convertible for a one
percentage point change in the assumption for stock volatility.
Volatility Share price volatility is a measure of the dispersion of share price returns. It is defined
as the annualised standard deviation of returns. The extent to which the underlying
share price has fluctuated over a certain period determines the historical or observed
volatility. The assumption for future share price volatility is an input for
convertible valuation.
Yield advantage The yield advantage is the difference between the current yield on the convertible
bond and the stock dividend yield.
Yield to maturity Yield to maturity (YTM) is the discount rate that equates the current market price
of a straight bond to the present value of its future cash flows.

61
Convertible Bonds – February 2002

Notes

62
Convertible Bonds – February 2002

Notes

63
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© Salomon Smith Barney Inc., 2002. All rights reserved. Any unauthorised use, duplication, redistribution or disclosure is prohibited by law and will
result in prosecution.

2002- EU19289

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