mini-course series - income (part 5)

Copyright © 2012 by Institute of Business & Finance. All rights reserved.

MINI-COURSE SERIES

RETIREMENT INCOME

Part V

RETIREMENT INCOME 1

PART V

IBF | MINI-COURSE SERIES

CONVERTIBLE BONDS

Convertible bonds look and act like a bond, but they can also look and act like common

stock. Investors are attracted to convertibles because they pay an enticing and steady in-

come while you wait for the stock price to move higher.

Convertible bonds (converts) are similar to traditional fixed income investments in that

they pay income twice a year, have a maturity date and are sometimes callable. In fact, in

The Wall Street Journal they appear with the listed corporate bonds. They are different

from traditional bonds in that they offer the option to convert the bonds into a certain

number of the issuer’s common stock shares at a specified price. How many shares of

common stock each convertible bond can be exchanged for when it is converted is set by

the convert’s conversion ratio when the convertible is issued.

Value of Convertible Bond as Stock

Conversion Ratio* Stock’s Market Price Value of Convertible as Stock

40 $10 $400

40 $18 $720

40 $25 $1,000

40 $30 $1,200

40 $35 $1,400

* number of shares the convertible is exchanged into

Convertibles are bonds that can become stock; its value responds to changes in the

stock’s price and the credit quality of the company. Interest rates have little impact be-

cause convertibles tend to have low yields.

XYZ Corporation

Security Yield

Stock 0%

Convert 6%

Bond 8%

In the preceding example, you can see converts tend to yield more than the common

stock and straight debt tends to yield more than the convert. The convertible’s long-term

stock option (option to convert into shares of stock) is valuable, so the company can pay

lower interest than on its straight debt (a traditional bond).

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The conversion price is established at issue. It is usually much higher than the stock price

is when the convertible bond is issued. For example, imagine ABC Inc. convertible bonds

are issued on May 10, 2010, when the common stock is trading at $15 per share. Their

conversion price is $25 per share. If you decide to convert, you trade in the convertible

bond and pay $25 a share for the common stock; you then own the common stock instead

of the convert. Converting into common stock is obviously not something you would do

until the stock price rises higher than the conversion price of $25 per share.

If you are familiar with options, it may help to think of a convertible as a bond trading

with an attached stock (call) option. When the bond is issued, the convertible’s conver-

sion price is like an out-of-the-money call option’s strike price. At this point the conver-

sion option is not worth much because the likelihood of its being exercised is remote.

Conversion option does not appreciate much in value until the underlying stock price gets

closer to the conversion (strike) price and it becomes more likely the conversion option

will be exercised.

When the stock’s market price rises above the conversion price and the stock is now

yielding more than the convertible, the convertible’s option is in-the-money. As long as

this is the relationship, the convertible price moves in lockstep with the underlying

stock’s value price. This is because it is now profitable to convert the bond into stock.

The convertible has become a proxy for the stock, mimicking its behavior.

Most convertibles are callable. When the company decides to call a convertible, it must

notify you ahead of time so you have time to convert if you wish. Convertible bond calls

may be expressed as a conditional statement. For example, “This bond is noncallable for

four years from date of issue unless the common stock sells at 140% of conversion price

for 30 consecutive trading days.” If the common stock’s price trades at levels 40% above

the convertible’s conversion price for 30 trading days straight, the issuer can call the con-

vert. So, if the conversion price is $25, and the stock trades at $35 for 30 trading days, the

company could call the bond.

If a company files for bankruptcy, convertible bondholders are usually behind traditional

bond investors and in front of preferred and common stock owners in the line of lien

holders trying to claim a piece of the failing company’s assets. This seniority tends to

provide convertibles with more downside price protection than the company’s preferred

or common stock because of its place in the capital structure.

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Options

When you buy an option, you are paying for the opportunity to do something in the future

should you so choose. For example, when you buy a call, you are paying for the chance

to buy a commodity like corn, a stock or a bond at a certain price. This price is called the

strike price. You are hoping the price of the bond you have bought a call on will rise

above the strike price, so you can buy the security at a lower-than-market price. If the

price does move higher, you could exercise the option, buy the bond and sell it at the

higher market price for a profit. Options have an expiration date after which the contract

ceases to exist, so the market has to move higher before then for you to make any money.

When you buy a call, you are buying the option to purchase the bond at a certain price.

When you sell a call, you receive a call premium (option cost) from the call buyer. You

are giving that person the right to call the bond away from you. You are hoping the price

does not move higher so the person will not call your security away at a lower-than-

market price. You will be able to keep the bond, and have made money from having sold

the now worthless call. Selling a call is also known as writing a call.

Call options involve the right to call the bond away from the owner. Put options involve

the right to force someone to buy your bond at a higher-than-market price. When you buy

a put, you are paying for the right to sell your bond at a certain price to the person who

sells you the put. You are protecting yourself from having the price of your security drop.

If the price does fall, you can sell your bond at a higher than-market price, limiting loss-

es. The put seller is hoping the price of the bond will not fall, so the premium you paid

will be clear profit without any consequences. The put seller does not want to have to pay

above-market prices for the bond.

Options themselves can be traded in the secondary market once the contract has been

written. Their value is based on how much time until the option expires (theta), how vola-

tile the market is (vega), and where market price is versus the strike price. The option is

worth more the more time there is until expiration, the more volatility there is in the mar-

ket and the more in-the-money it is. A call is in-the-money when the security’s market

price is above the strike price. A put is in-the-money when the security’s market price is

below the strike price.

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WHEN TO BUY CONVERTIBLES

It makes sense to buy a convertible if you think it will be in-the-money in the near future

or the yield is high enough to make it worth the wait to see if it will be in-the-money at

some point. To help decide if the latter is the case, follow these steps:

[1] Calculate the convert’s yield advantage versus the common stock yield.

[2] Calculate how much you are paying for the conversion option; it is the difference between the

price you are paying and the price you would pay if the bond were not convertible. It is known as

the (convertible) premium.

[3] See if the yield advantage (step 1) is greater than the premium you are paying (step 2) for the

ability to convert into stock. Pretend today’s date is 4/30/10 and we are looking at XYZ Co.

Common Stock

Price: 31 5/8 Annual dividend: $1.25

Convertible Bond

Issued in 2010 BB-rated

Coupon: 7.5% Maturity: 9/10/24

Current market price: 97 Callable 4/2/12 at 105.08

Conversion price: $44.25

Conversion ratio: 22.599

Remember, conversion ratio tells you how many shares of common stock each converti-

ble bond can be exchanged for when it is converted. If it is not given to you, you can cal-

culate it:

Conversion ratio = Par value ÷ Conversion price

= $1,000 ÷ $44.25

= 22.599

This means each XYZ convertible bond can be exchanged for 22.6 shares of ABC com-

mon stock. In order to make a decision, take the above information through the following

steps:

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PART V


Step 1: Find the Yield Advantage

Start by calculating the common stock’s yield:

Stock yield = Dividend ÷ Current price

= $1.25 ÷ 31.625

= 4%

Then calculate the convertible’s yield:

Convert current yield = Coupon ÷ Current price

= 71/2% ÷ 97

= 7.7%

To calculate the convertible’s yield advantage, subtract stock’s yield from convert’s

yield:

Yield advantage = Convert yield – Stock yield

= 7.7% – 4%

= 3.7%

Step 2: Find the Convertible’s Premium

Start by calculating what the bond’s theoretical price would be if you stripped off the

conversion option, so it became a straight bond. This cannot really be done—it is just a

theoretical concept, so you can compare it with the convert’s current price to see the val-

ue of the option. This theoretical price is known as parity.

Parity = Current stock price × Conversion ratio

= 31.625 × 22.599

= $714.69

Then divide the current price by the theoretical price (parity):

Premium = Bond’s current dollar value ÷ Parity

= $970 ÷ $714.69

= 35.7%

= 1.357 = 35.7% premium

You subtract 1 from 1.357 and your result is the percentage change: 35.7%. You can also

use this method to find percentage increases. Say you had $5,000 and it earned 5%. To

calculate its value in one year you would multiply $5,000 times (1 + .05):

$5,000× 1.05 = $5,250

This premium shows you how much the bond is trading above the bond’s theoretical val-

ue at the conversion price. The higher the percentage the bond’s actual value is above the

theoretical value (parity), the further you need the common stock’s price to rise before

you can convert the bond.

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Be careful not to confuse this use of the word “premium” with the other meaning: a bond

selling at a price above par. Make sure when discussing converts and premiums you

know which definition the other person is using.

There is an assumption in this calculation the stock, stock dividend and convert’s market

value do not change. This is an estimate used only as a benchmark to gauge your premi-

um recovery period projections against. It tells you how long you will have to earn to

earn back the premium you paid over the bond’s theoretical value (bond’s worth w/o its

conversion feature).

Premium recovery period = {Premium ÷ [(100 + Premium) ÷ 100]} ÷ Yield advantage period

= {35.7 ÷ [(100 + 35.7) ÷ 100]} ÷ 3.7

= [35.7 ÷ (135.7 ÷ 100)] ÷ 3.7

= (35.7 ÷ 1.357) ÷ 3.7

= 26.308 ÷ 3.7

= 7.1 years

With these calculations completed, you can compare the 7.1 years to the bond’s maturity

(or call date, if likely to be called). If the premium recovery (break-even period) is longer

than these dates, you would buy the convert only if you felt certain the stock was moving

higher and would be likely to be profitably converted. Even then, it may make sense just

to buy the stock.

Convertibles Funds [through 2011]

Year Return Year Return Year Return

2011 -5% 2006 11% 3 years 3.0%*

2010 17% 2005 4% 5 years 5.5%*

2009 42% 2004 9% 10 years 4.6%*

2008 -34% 2003 27% 15 years 7.8%*

2007 9% 2002 -9%

*annualized

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PART V


THINGS TO DO

Your Practice

Consider making convertibles a category that could comprise 5-15% of a client’s port-

folio. Understand that this part equity and part debt instrument is usually issued by

corporation’s whose rating is below investment grade.

The Next Installment

Your next installment, Part VI, covers IRAs and distribution strategies. You will re-

ceive Part VI in a few days.

Learn

Are you ready to take your practice to the next level? Contact the Institute of Business

& Finance (IBF) to learn about one of its five designations:

o Annuities – Certified Annuity Specialist® (CAS

®)

o Mutual Funds – Certified Fund Specialist® (CFS

®)

o Estate Planning – Certified Estate and Trust Specialist™

(CES™

)

o Retirement Income – Certified Income Specialist™

(CIS™

)

o Taxes – Certified Tax Specialist™

(CTS™

)

IBF also offers the Master of Science in Financial Services (MSFS) graduate degree.

For more information, phone (800) 848-2029 or e-mail [email protected].

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mini-course series - income (part 5)

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