Convertible Securities Chapter 4 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company1 What is it? Convertibles are

Convertible Securities Chapter 4Tools & Techniques of

Investment Planning

Copyright 2007, The National Underwriter Company 1

What is it?

• Convertibles are bonds or preferred stocks that may be converted at a specified conversion price (per share) or conversion ratio (number of shares) into the common stock of the firm issuing the securities.– There are many variations, which allow a holder to exchange,

trade in, or convert the security being held into another type of security.

– They are hedge-type instruments that allow investors to enjoy much of the upside potential of a riskier investment while bearing the smaller downside risk more commonly associated with investments offering less upside potential.


Investment Planning


When is the use of this tool indicated?

• When the investor would like to combine an element of certainty with the opportunity for significant capital gains.– The element of certainty is achieved through a fixed interest or

dividend rate and a known payment schedule.• When the investor needs current cash flow that

provides a higher rate of return than available from the dividends on common stock.

• When the investor at the same time is willing to accept a somewhat lower rate of current income than might be available on bonds and preferred stocks that do not have the conversion feature


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Advantages

• There is a high degree of security for both principal and income.– The general credit of the issuing corporation stands behind payments.– Preferred stockholders are protected by the cumulative nature of most

preferred dividends.• Convertible securities offer the potential for capital growth through

ownership of the common stock.– This appreciation is provided by:

• The conversion and actual ownership of the common stock of a corporation.

• The appreciation in the market value of the convertible bond or preferred stock that occurs as a result of an increase in the price of the common stock.

– If the underlying stock price rises above the value of the convertible as a fixed income security, the convertible’s price will move in almost direct relation to the price of the common stock.


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Example

• A bond convertible into 50 shares of common stock that sells for about $1,000 as a fixed income security will sell for at least $1,500 if the common stock increases in value from $20 per share to $30 per share.


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Advantages

• The basic form offers some protection in the event that common stock prices decline.– A “floor” under the price of the convertible security is provided

by the intrinsic worth of the bond or preferred stock.

• Convertible securities typically pay a higher rate of return in the form of interest or dividends than is available from the company’s common shares.– Many companies that issue convertible securities pay no

current dividends on their common stocks.


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Advantages

• The investor controls the form of investment and the timing of the conversion.– In some cases, a corporation may effectively force conversion

by exercising the call feature common to almost all convertible securities.

• The change in the nature of the investment can be effected quickly and with little or no cost to the investor.– The investor merely sends the convertible security to the issuer

and requests the change.– Typically, there are no fees or charges associated with the

transaction.


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Disadvantages

• Until the conversion has been made, the investor is relatively unprotected from the effects of inflation.– This is due to the fixed nature of interest payments on convertible

bonds and the fixed dividend rate on convertible preferred stocks.• The yields provided by convertible securities are often

significantly below the yields of alternative investments.– Since convertibles provide both upside potential and downside

protection, investors must pay a premium for the securities.• If the price of the underlying common stock does increase

substantially, the value of the convertible will never increase as much as the value of the underlying common stock because of the premium paid for the convertible.


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Disadvantages

• Typically, convertible bonds are callable by the issuing corporation at a price slightly about their par value.– Companies can use this feature to force conversion if the price

of the bond has appreciated to a point well above the call price.– This conversion may be forced earlier than the investor

planned.• The investor will not have recovered the premium paid to purchase

the convertible, making the return less than if the underlying common stock had been purchased outright.


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Example

• A bond convertible into 50 shares of common stock will sell for at least $1,500 if the stock is trading at $30 per share. The same bond may have a call price of only $1,080. If the issuer were to call the bond, investors would be forced to convert their bonds into common stock or face the loss of $420 per bond.


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Disadvantages

• Convertible issues tend to be of relatively small size when compared with regular bond and stock issues.– With fewer convertibles outstanding, trading is less active and

may result in a lack of liquidity when buying or selling a particular issue.

• Generally, convertible bonds are subordinated to all other debt issued by the firm.– Default risk is higher than for other nonconvertible debt.

• Because of the complex nature of convertibles as hybrid securities, a more involved and detailed selection process is necessary


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Tax Implications

• Income received from a convertible bond or preferred stock is subject to ordinary income tax rates.

• Appreciation is not taxable until the investor sells the bond, preferred stock, or the common shares received on conversion.– Original issue discount on a convertible bond may be includable as it

accrues.• Conversion itself is not a taxable event.

– The investor takes as his cost basis the price paid for the original investment.

– If the conversion feature is not detachable, there is no allocation of basis to the two components of the security.

• Basis is carried over to the common shares.


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Example

• Nancy Manzi purchased a convertible bond for $800. She later converted the bond into 40 shares of the issuing company’s common stock. Nancy’s cost basis for those 40 shares of common stock is $800, a carryover of her original investment. This results in a cost basis for the common stock of $20 per share ($800 / 40 shares).


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Tax Implications

• Profits or losses on the sale of a convertible bond or preferred stock, or on the maturity of a convertible bond, are treated as capital gains or losses.– Market discount and original issue discount realized on sale

or maturity of a bond may have to be treated as interest.– Long-term capital gains are generally taxable at a maximum

rate of 15%.– Capital losses may be used to offset only capital gains and

up to $3,000 of ordinary income per year.


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Alternatives

• Convertible bonds with a premium put – Offer additional downside protection– Issued at face value – Include a put option that allows the investor to redeem the bonds

for cash at a premium relative to the bonds’ face value at a future date

– Typically pay lower interest than non-convertibles• Mutual funds specializing in convertible securities • Bond issues with equity warrants

– These are essentially just convertible bonds with a detachable conversion feature.

– If the warrant is detachable, the bond and warrant will be treated for tax purposes as separate instruments.


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Alternatives

• Investors could also “package” their own form of convertible by combining stock purchase warrants or call options with straight bonds.– Stock purchase warrant: An option to buy stock at a stated price for a

given period of time.• Pays no income• Allows investors to determine the timing of their purchase• Offers the opportunity for appreciation• Provides leverage in that the exercise price of the warrant is generally fixed

in the same manner as the conversion price of a convertible bond or convertible preferred stock.

– Satisfies the investors twin objectives of capital gain potential (through the warrant) and current income (through the straight bond).


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Where and How do I get it?

• Full service brokerage firms– Investors can purchase directly by calling and placing an

order.• Discount brokerage firms

– Many banks and thrift institutions also provide discount brokerage services.

• Mutual funds– Offer the benefits of diversification and professional

management– Eliminate the need for the investor to analyze various bonds

and to select the most attractive at any given time.


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What fees or other acquisition costs are involved?

• Brokerage fees on the purchase of the convertible bonds– Similar to those paid in buying regular bonds– Approximately $5 to $20 per bond, depending on:

• The total value of the transaction• The number of bonds purchased• Whether or not a discount broker is used

– Some firms will charge a minimum fee of $30 regardless of the number of bonds being bought or sold


Investment Planning


How do I select the best of its type?

• Look for a record of increasing earnings for at least the past 5 years and assets well in excess of the face value of the bonds.

• For a new issue, the investment banking firm that underwrites the issue and offers it to the public should be a member of a major stock exchange.

• Investors may prefer convertibles offered by companies in growth industries.– Companies experiencing growth in earnings per share (EPS) are

likely to have their stock price increase as well.– Buyers looking to convert their bonds into stock or sell the bonds at

an appreciated value should consider the gain in value caused by growth in EPS, as the convertible bonds will also increase in price.


Investment Planning



• Calculate the payback period – Payback period indicates how long it will take the investor

to recoup the premium paid for the bond over its conversion value from the added yield of the convertible security.1. Conversion Ratio = Bond face value ($1,000) divided by

conversion price2. Conversion Value = Conversion ratio multiplied by the current

market value of one share of stock3. Conversion Premium = The amount the convertible price

exceeds the conversion value (% by dividing the difference by the conversion value)

4. Yield Advantage = The amount by which the current yield on the bond exceeds the yield on the common

5. Payback Period = The premium divided by the yield advantage


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• The interest paid on the convertible bond should be within two percentage points of the rate paid on similar quality, nonconvertible bonds.– Investors should not sacrifice too much in terms of current

income in exchange for the speculative feature of converting to common stock in the future.


Investment Planning


Where can I find out more about it?

• Statistical rating agencies– Standard & Poor’s (www.standardandpoors.com)– Moody’s Investors Service (www.moodys.com)

• Various publications specializing in convertible bonds– Value Line Convertible Survey, Arnold Bernhard & Company, Inc., 711

Third Avenue, New York, NY 10017• Major brokerage firms• Newspapers that quote bonds daily

– The New York Times– The Wall Street Journal

• Other internet sources– Bondsonline (www.bondsonline.com)– Convertbond (www.convertbond.com)

http://www.standardandpoors.com/

http://www.moodys.com/

http://www.bondsonline.com/

http://www.convertbond.com/

Documents

Convertible Securities Chapter 4 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company1 What is it? Convertibles are