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Convertible bonds

Fixed-income securities that can be converted into stocks


Forms of convertible securities
Standard-coupon convertibles Zero-coupon convertibles Standard convertible preferred stock Hybrid convertible preferred stock, such as mandatory convertibles

Convertible bonds are xed-income investments with features that allow the holder to convert the bonds into a specic amount of stock shares in the same company. They are best-suited for investors who seek both income from the bond and the growth potential of the stock.
Convertible bonds were key nancial building blocks in our Western heritage, fueling the growth of railroad and telephone companies in the late 1800s. The bonds virtually disappeared when double-digit ination rates in the 1970s sent bond buyers searching for other ways to protect their investments. Now, investors who seek both interest income and the ability to grow principal in the markets appreciate the exibility offered by convertible bonds.

Understanding convertible securities


Essentially, convertible securities are debt instruments because they pay interest and have stated maturity dates. Though they typically rank higher than all equity securities in the event of liquidation, convertibles are usually issued as subordinated debt and therefore carry more default risk than senior debt. Originally, convertibles were issued with a feature that gave holders the option but not the obligation to convert to a specied number of shares of common stock. However, some new issues of convertible securities automatically convert at maturity.

How does the conversion feature work?


The value of convertible securities, like all bonds, depends on prevailing interest rates and the credit quality of the issuer. The exchange feature of a convertible bond gives the holder the right to convert the par amount of the bond into common shares at a specied price or conversion ratio. For example, a conversion ratio might give the holder the right to convert $100 par amount of the convertible bonds of ABC Corporation into its common shares at $25 per share.* The conversion ratio is four to one. The conversion ratio is described in the prospectus or offering document when the bond is rst issued.
*This information is hypothetical and is provided for informational purposes only. It is not intended to represent any specic return, yield, or investment nor is it indicative of future results.

Because convertible bonds can be turned into common stock, they usually pay a slightly lower interest rate than bonds without this feature. If the stock price rises, the bond price should also rise. Since most convertible bonds are also callable, the company can force investors to convert the bonds to common stock by calling the bonds in a practice called forced conversion.
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Calculating the conversion premium


The bond value is an estimate of the price of a bond (based on the interest rate paid) with no conversion option. The conversion premium is calculated as: (price - parity) ____________________________ parity where parity is the equity value. When comparing convertible securities to the underlying common stock, investors need to understand that when an issuing companys common-stock price moves higher, the conversion privilege become more valuable unless its a busted convertible. As a result, the price of the convertible security should also move higher more often than not. As the price of the common stock moves higher, this security will start to be valued more like a stock and less like a bond. If the price of the common stock falls, the conversion feature becomes less valuable and the convertible price may also decline. The bond characteristics of the security will tend to moderate the decline. In a declining equity market, the features of a convertible security may offer some downside protection.

When a bond is converted to common stock, the company that converted the bond to stock has less debt: what was debt becomes equity. As a result, converting debt (bonds) into equity (stock) dilutes the value of all the shares in the company the percentage of each stockholders equity in the company has been reduced. If the companys stock declines to a price that makes the convertible feature of the bond worthless (but the company continues to make interest and principal payments), the bond will trade based on its yield like any other bond.

How does the stock market affect convertible bonds?


As an investor, please be aware that when an issuing companys common stock price moves higher, the conversion privilege becomes more valuable. When that happens, the price of the convertible bond should also rise. As the price of a companys common stock increases, the value of its convertible bonds will be viewed more like stock and less like bonds. Likewise, if the stock price falls, the conversion feature becomes less valuable and the price of the convertible may also decline. Because bonds are ranked higher than stocks in the event of liquidation, a convertible bond can help cushion the fall in a declining equity market and offer some downside protection.

Why do companies issue convertible securities?


Convertible securities are issued by companies that are willing to give up corporate ownership of some outstanding equity shares in order to borrow money. As with other types of xed-income securities, the higher the credit rating assigned to the underlying security, in general, the lower the interest rate on the bond. The chart on page 3 explains credit ratings.

Who buys convertible bonds?


Convertible bonds appeal to investors who are interested in the income offered by a bond but are also interested in the common stocks growth potential. Many convertible bond investors, for example, rst track the issuers common stock. Then, the investors decide to buy bonds and obtain additional income from the required interest payment, and later convert the bonds to stock in the same company. However, these bonds are not suited to all types of investors as it requires knowledge of specic factors.

What are other factors to understand when buying convertible bonds?


When considering a purchase of convertible securities, investors should understand conversion premium, premium recovery and call features. Conversion premium. The conversion premium is the difference between the cost of the bonds and the value of the stock into which the bonds can be converted. Typically, a convertible will sell for a premium of 25 to 30% more than the underlying common stock. The higher the premium, the longer it will take for the bond to reach the value of the stock but a low premium should not be used as the sole criterion in evaluating a bond. Premium-recovery or break-even time. This is the calculation of how long it will take the investor to recover the premium paid for the convertible bond. Its usually between two and three years. The premium-recovery period is important to keep in mind because it has a direct effect on the timing of an investment.

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Call features. Finally, when investing in convertibles, it is essential for investors to know the bonds call features when the issuing company can redeem the bonds for common stock or cash. A call can be made even when the price is below the bonds conversion value. Most convertible bonds have call protection for a minimum of two years from the date of issue.

Potential benets
With convertible bonds, you can receive income payments from a bond while reaping some of the benets of a companys rising stock price. If the stock is not performing well, the bondholder has priority to be paid interest, ahead of any stockholder dividends. Also, if the stock price increases, the bondholder has the choice of converting the bonds into a specied number of common stock shares.

Credit ratings
Moodys Investment-grade ratings Highest possible credit rating principal and interest payments considered very secure. High quality differs from highest rating only in the degree of protection offered to bondholders. Good ability to pay interest and principal more susceptible to adverse effects due to changing conditions. Adequate ability to make principal and interest payments adverse conditions are more likely to affect ability to service debt. Speculative ratings Issuer faces ongoing uncertainties or exposure to adverse business or economic conditions. Greater vulnerability to default, but currently meeting debtservice requirements. Current identiable risks of default in some cases, bonds may already be in default. Bonds in default. Ba BB BB BB Aaa AAA AAA AAA Standard & Poors Fitch Duff & Phelps

Aa

AA

AA

AA

Baa

BBB

BBB

BBB

Caa C

CCC D

CCC D

CCC D

This chart will help you identify the meanings behind the credit ratings assigned to convertible bonds. Bonds rated Baa/BBB or above are considered to be of investmentgrade quality, meaning that the bonds can be considered for the conservative investor. Corporate bonds rated below this level are considered to be speculative or high-yield investments and are only suitable for investors who are able to accept a greater degree of risk from their investments in exchange for a potentially higher return.

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Glossary
Call protection. The period of time during which a convertible security cannot be called by the issuing company. Conversion price. The price (or cost) at which a convertible security can be converted into the underlying common stock. Conversion price equals the par amount of the security divided by the conversion ratio. Conversion ratio. The number of shares into which a bond or preferred stock may be converted. Coupon or dividend. The xed interest rate paid to the holder for the term of the security. Parity. Equity value of a convertible security, determined by multiplying the conversion ratio by the stock price. Premium. The percentage by which a convertible security is valued over its parity.

Risk factors
Convertible securities typically involve credit or default risk, event risk, call or redemption risk and market risk. Credit risk. Credit risk is the risk that an issuer will be unable to make the periodic interest payments or repay the principal. When a bond stops paying interest or the issuer is unable to repay the principal, the bond is considered to be in default. If the corporation declares bankruptcy and defaults on its debt, bondholders, as creditors of the corporation, will have priority over stockholders in the bankruptcy proceedings. To assess a bonds credit risk, investors can look to the credit ratings assigned by independent credit-rating agencies, which include Moodys Investors Service, Standard & Poors, Fitch Investors Service, Inc. and Duff & Phelps Credit Rating Company. Normally, the lower the rating on a bond, the higher the potential yield. Issuers must compensate investors for assuming additional credit risk by offering higher interest rates on corporate bonds. Please make sure to check the credit-rating of a corporate bond before you make a purchase. Event risk. Event risk in convertible securities is normally associated with events affecting the corporate issuer. Leveraged buyouts, mergers, takeovers or recapitalizations can often increase a corporations debt load. These factors can have a serious impact on the credit ratings assigned to a corporate issuer, as well as the value of the bond. Call or redemption risk. Often, convertible bonds are issued with redemption features that allow a corporate issuer to redeem or call an issue or to force a conversion at a stated date before the bond matures. Market risk. Convertible bonds, like other types of xed-income investments, are always subject to market risk. This refers to the risk that an investor faces if the bond needs to be sold before its stated maturity. As interest rates increase, bond prices will decrease and, conversely, as interest rates decrease, bond prices will increase. While it is true that rising interest rates will have a negative effect on the bond value of the convertible security, the fact that the convertible also has equity value will tend to temper that effect. If the stock market is rising, convertible values will generally be more positively affected by rising stock values than negatively affected by rising interest rates. However, if the stock market declines at the same time that interest rates rise, convertibles normally lose value.

Summary
Convertible bonds can be a valuable addition to your xed-income portfolio. Your Financial Advisor can help you determine whether these bonds will suit your overall investment objectives. For more information on convertible bonds and your portfolio, consult your Financial Advisor today.

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