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Convertible bond
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Convertible bond
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{{Short description|Type of bond}}{{Financial markets}}{{More citations needed|date=August 2018}}In finance, a convertible bond, convertible note, or convertible debt (or a convertible debenture if it has a maturity of greater than 10 years) is a type of bond that the holder can convert into a specified number of shares of common stock in the issuing company or cash of equal value. It is a hybrid security with debt- and equity-like features.NEWS, Scatizzi, Cara, Convertible Bonds,www.aaii.com/journal/article/convertible-bonds.touch, 8 September 2015, The AAII Journal, February 2009, It originated in the mid-19th century, and was used by early speculators such as Jacob Little and Daniel Drew to counter market cornering.BOOK, A Financial History of the United States: From Christopher Columbus to the Robber Barons, 2002, M. E. Sharpe, 0-7656-0730-1, 161, Jerry W. Markham, Convertible bonds are most often issued by companies with a low credit rating and high growth potential. Convertible bonds are also considered debt security because the companies agree to give fixed or floating interest rate as they do in common bonds for the funds of investor. To compensate for having additional value through the option to convert the bond to stock, a convertible bond typically has a coupon rate lower than that of similar, non-convertible debt. The investor receives the potential upside of conversion into equity while protecting downside with cash flow from the coupon payments and the return of principal upon maturity. These propertiesâand the fact that convertible bonds trade often below fair valueJOURNAL, Ammann, Manuel, Kind, Axel, Wilde, Christian, Are Convertible Bonds Underpriced?: An Analysis of the French Market, Journal of Banking and Finance, 27, 4, 635â653, 2003, 268470, 10.1016/S0378-4266(01)00256-4, âlead naturally to the idea of convertible arbitrage, where a long position in the convertible bond is balanced by a short position in the underlying equity.From the issuer’s perspective, the key benefit of raising money by selling convertible bonds is a reduced cash interest payment. The advantage for companies of issuing convertible bonds is that, if the bonds are converted to stocks, companies’ debt vanishes. However, in exchange for the benefit of reduced interest payments, the value of shareholder’s equity is reduced due to the stock dilution expected when bondholders convert their bonds into new shares.Convertible notes are also a frequent vehicle for seed investing in startup companies, as a form of debt that converts to equity in a future investing round.JOURNAL, Gilson, Ronald, Schizer, David, Understanding Venture Capital Structure: A Tax Explanation for Convertible Preferred Stock, Harvard Law Review, 2003, 116, 3, 874â916, 1342584, 10.2307/1342584,scholarship.law.columbia.edu/faculty_scholarship/1264, It is a hybrid investment vehicle, which carries the (limited) protection of debt at the start, but shares in the upside as equity if the startup is successful, while avoiding the necessity of valuing the company at too early a stage.- the content below is remote from Wikipedia
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Types
Underwriters have been quite innovative and provided several variations of the initial convertible structure. Although no formal classification exists in the financial market it is possible to segment the convertible universe into the following sub-types:Vanilla convertible bonds
Vanilla convertible bonds are the most plain convertible structures. They grant the holder the right to convert into a certain number of shares determined according to a conversion price determined in advance. They may offer coupon regular payments during the life of the security and have a fixed maturity date where the nominal value of the bond is redeemable by the holder. This type is the most common convertible type and is typically providing the asymmetric returns profile and positive convexity often wrongly associated to the entire asset class: at maturity the holder would indeed either convert into shares or request the redemption at par depending on whether or not the stock price is above the conversion price.Mandatory convertibles
Mandatory convertibles are a common variation of the vanilla subtype, especially on the US market. Mandatory convertible would force the holder to convert into shares at maturityâhence the term “Mandatory”. Those securities would very often bear two conversion prices, making their profiles similar to a “risk reversal” option strategy. The first conversion price would limit the price where the investor would receive the equivalent of its par value back in shares, the second would delimit where the investor will earn more than par. If the stock price is below the first conversion price the investor would suffer a capital loss compared to its original investment (excluding the potential coupon payments). Mandatory convertibles can be compared to forward selling of equity at a premium.Reverse convertibles
Reverse convertibles are a less common variation, mostly issued synthetically. They would be opposite of the vanilla structure: the conversion price would act as a knock-in short put option: as the stock price drops below the conversion price the investor would start to be exposed the underlying stock performance and no longer able to redeem at par its bond. This negative convexity would be compensated by a usually high regular coupon payment.Packaged convertibles
Packaged convertibles or sometimes “bond + option” structures are simply a straight bond and a call option/warrant wrapped together. Usually the investor would be able to then trade both legs separately. Although the initial payoff is similar to a plain vanilla one, the Packaged Convertibles would then have different dynamics and risks associated with them since at maturity the holder would not receive some cash or shares but some cash and potentially some share. They would for instance miss the modified duration mitigation effect usual with plain vanilla convertibles structures.Contingent convertibles
Contingent convertibles are a variation of the mandatory convertibles. They are automatically converted into equity if a pre-specified trigger event occurs, for example if the value of assets is below the value of its guaranteed debt.Foreign currency convertibles
Foreign currency convertibles are any convertible bonds whose face value is issued in a currency different from issuing company’s domestic currency.Exchangeable bond
Exchangeable bond where the issuing company and the underlying stock company are different companies (e.g. XS0882243453, GBL into GDF Suez). This distinction is usually made in terms of risk i.e. equity and credit risk being correlated: in some cases the entities would be legally distinct, but not considered as exchangeable as the ultimate guarantor being the same as the underlying stock company (e.g. typical in the case of the Sukuk, Islamic convertible bonds, needing a specific legal setup to be compliant with the Islamic law).Synthetic bond
Synthetically structured convertible bond issued by an investment bank to replicate a convertible payoff on a specific underlying equity. Sometimes referred also as Cash settled Bank Exchangeable Bonds (e.g. Barclays/MSFT 25 US06738G8A15 - Barclays Bank PLC is the issuer while Microsoft is the referenced underlying equity). Most reverse convertibles are synthetics. Synthetics are more similar to structured products with settlement done in cash and no equities being produced as the result of a conversion. The Packaged Convertibles (e.g. Siemens 17 DE000A1G0WA1) are sometimes confused with synthetics due to the fact an issuer (sometime a portfolio manager) will create a structure using straight bonds and options. There are in reality two completely different products with different risks and payoffs.Structure, features and terminology
- Coupon: Periodic interest payment paid to the convertible bond holder from the issuer. Could be fixed or variable or equal to zero.
- Maturity/redemption date: The date on which the principal (par value) of the bond (and all remaining interest) are due to be paid. In some cases, for non-vanilla convertible bonds, there is no maturity date (i.e. perpetual), this is often the case with preferred convertibles (e.g. US0605056821).
- Final conversion date: Final date at which the holder can request the conversion into shares. Might be different from the redemption date.
- Yield: Yield of the convertible bond at the issuance date, could be different from the coupon value if the bond is offering a premium redemption. In those cases the yield value would determine the premium redemption value and intermediary put redemption value.
- Bond floor: Also known as straight bond value, this is the value of a convertible bond’s fixed income elements (regular interest payments, payment of principal at maturity and a superior claim on assets compared to common stock) excluding the ability to convert into equities.BOOK, Fabozzi, Frank J., Bond Markets, Analysis and Strategies, 1996, Prentice-Hall, Inc., Upper Saddle River, NJ, 0-13-339151-5, 376, third,
- The issuance prospectus will state either a conversion ratio or a conversion price. The conversion ratio is the number of shares the investor receives when exchanging the bond for common stock. The conversion price is the price paid per share to acquire the shares when exchanging the bond for common stock.BOOK, Ritchie Jr., John C., The Handbook of Fixed Income Securities, Frank J. Fabozzi ed., 1997, McGraw Hill, New York, 296, 0-7863-1095-2, 5th,
- Market conversion price: The price that the convertible investor effectively pays for the right to convert to common stock. It is calculated as shown below. Once the actual market price of the underlying stock exceeds the market conversion price embedded in the convertible, any further rise in the stock price will drive up the convertible security’s price by at least the same percentage. Thus, the market conversion price can be thought of as a “break-even point.“BOOK, Fabozzi op cit, 376,
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