HIGH Grade HIGH Grade Convertible BondsConvertible Bonds

By T.J. KaleikiniBy T.J. Kaleikini

What is a Bond?What is a Bond?

a certificate of debt (usually a certificate of debt (usually interest-bearing or discounted) interest-bearing or discounted) that is issued by a government that is issued by a government or corporation in order to raise or corporation in order to raise money; the issuer is required to money; the issuer is required to pay a fixed sum annually until pay a fixed sum annually until maturity and then a fixed sum to maturity and then a fixed sum to repay the principalrepay the principal

DefinitionDefinition InIn financefinance, a convertible bond (or , a convertible bond (or

convertible debenture) is a type of convertible debenture) is a type of bondbond that can be converted into shares of that can be converted into shares of stock in the issuing company, usually at stock in the issuing company, usually at some pre-announced ratiosome pre-announced ratio

A bond that can be converted into a A bond that can be converted into a predetermined amount of the company's equity predetermined amount of the company's equity at certain times during its life, usually at the at certain times during its life, usually at the discretion of the bondholder. discretion of the bondholder.

How it Works…How it Works…

The exchange feature of a convertible The exchange feature of a convertible bond gives the right for the holder to bond gives the right for the holder to convert the par amount of the bond for convert the par amount of the bond for common shares a specified price or common shares a specified price or "conversion ratio"."conversion ratio". For example, a For example, a conversion ratio might give the holder the conversion ratio might give the holder the right to convert $100 par amount of the right to convert $100 par amount of the convertible bonds of Ensolvint convertible bonds of Ensolvint Corporation into its common shares at Corporation into its common shares at $25 per share. This conversion ratio $25 per share. This conversion ratio would be said to be " 4:1" or "four to one".would be said to be " 4:1" or "four to one".

How it works contHow it works cont

Investors buy convertible bonds to Investors buy convertible bonds to gain a higher current yield and less gain a higher current yield and less downside, since the convertible downside, since the convertible should trade to it bond value in the should trade to it bond value in the case of a steep drop in the common case of a steep drop in the common share price. share price.

ExamplesExamples Example Example

Let’s say that TSJ Sports issues $10 million in three-year Let’s say that TSJ Sports issues $10 million in three-year convertible bonds with a 5% yield and a 25% premium. This convertible bonds with a 5% yield and a 25% premium. This means that TSJ will have to pay $500,000 in interest annually, or means that TSJ will have to pay $500,000 in interest annually, or a total $1.5 million over the life of the converts. a total $1.5 million over the life of the converts.

If TSJ’s stock was trading at $40 at the time of the convertible If TSJ’s stock was trading at $40 at the time of the convertible bonds issue, investors would have the option of converting those bonds issue, investors would have the option of converting those bonds for shares at a price of $50 ($40 x 1.25 = $50). Therefore bonds for shares at a price of $50 ($40 x 1.25 = $50). Therefore if the stock was trading at say $55 by the bond's expiration date, if the stock was trading at say $55 by the bond's expiration date, that $5 difference per share is profit for the investor. However that $5 difference per share is profit for the investor. However there is usually a cap on the amount the stock can appreciate there is usually a cap on the amount the stock can appreciate through the issuer’s callable provision. through the issuer’s callable provision. For instance, TSJ executives won’t allow the share price to For instance, TSJ executives won’t allow the share price to surge to $100 without calling the converts (recall the paragraph surge to $100 without calling the converts (recall the paragraph on forced conversion). Alternatively, if the stock price tanks to on forced conversion). Alternatively, if the stock price tanks to $25 the convert holders would still be paid the face value of the $25 the convert holders would still be paid the face value of the $1,000 bond at maturity. This means that convertible bonds limit $1,000 bond at maturity. This means that convertible bonds limit risk should the stock price plummet, while limiting exposure to risk should the stock price plummet, while limiting exposure to upside price movements of the underlying common stock. upside price movements of the underlying common stock.

How RiskyHow Risky

Not very risky because….Not very risky because….

By investing in converts you are limiting your downside risk at the expense of limiting your upside potential.

Risks!!Risks!!

Bonds, whether convertible or not, are only Bonds, whether convertible or not, are only as good as the strength of the company as good as the strength of the company behind it. In the past year or so, the credit behind it. In the past year or so, the credit quality of convertible bonds has dropped quality of convertible bonds has dropped off. off. 

Indeed, half of the convertible market Indeed, half of the convertible market comprises issues in technology and comprises issues in technology and telecommunications, both of which can be telecommunications, both of which can be volatile sectors. volatile sectors. 

Convertible funds also tend to be more Convertible funds also tend to be more expensive than domestic stock funds expensive than domestic stock funds because most carry loads, or sales because most carry loads, or sales charges. charges. 

And just because a fund invests in And just because a fund invests in convertible securities doesn't mean it will convertible securities doesn't mean it will always be less risky than a regular stock always be less risky than a regular stock fund. fund. 

Lose-Lose SituationLose-Lose Situation

Probably the most frustrating aspect of a Probably the most frustrating aspect of a convertible is its call feature - often overlooked convertible is its call feature - often overlooked in its evaluation. If interest rates should decline in its evaluation. If interest rates should decline significantly after the convertible bond is significantly after the convertible bond is issued, most companies can and will call their issued, most companies can and will call their bonds, in which case one loses the source of bonds, in which case one loses the source of what had been a relatively attractive income, what had been a relatively attractive income, and must then reinvest the proceeds in another and must then reinvest the proceeds in another vehicle at the then lower rates of interest. On vehicle at the then lower rates of interest. On the other hand, if interest rates go up, there is the other hand, if interest rates go up, there is no chance that the bond will be called, and so no chance that the bond will be called, and so the investor is stuck with a lower-than-market the investor is stuck with a lower-than-market rate of interest on the bonds. This is an rate of interest on the bonds. This is an example of a example of a "heads, you lose; tails, you "heads, you lose; tails, you don't win"don't win" type of investment type of investment

Who uses it?Who uses it?

PEOPLE WHO ARE: Sleepless PEOPLE WHO ARE: Sleepless because of market volatility? because of market volatility? You may want to consider You may want to consider convertible securities. convertible securities. 

investors in Generalinvestors in General