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Convertible Bonds: a Technical Introduction

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Convertible Bonds: a Technical Introduction Barclays Capital Convertible Bonds: A Technical Introduction Convertible Bonds Research – Tutorial 24 January 2002 Quantitative Research Convertible bonds have become an increasingly popular asset class in recent years, Luke Olsen +44 (20) 7773 8310 with substantial growth in markets across the globe. This has been driven by their [email protected] financial benefits and risk-reward profiles, as issuers and investors alike have gained an improved understanding of these complex and fascinating products. Convertible Research Douglas Decker, CFA This report aims to solidify the reader’s technical knowledge of convertibles, focusing +44 (20) 7773 8302 [email protected] on how the valuation of a convertible depends on its key features and characteristics. Haidje Rustau We expect that this will appeal to a diverse cross-section of interested parties, ranging +44 (20) 7773 8301 from sales/marketing professionals who wish to discuss with their clients the various [email protected] opportunities presented by convertibles, to hedge fund managers, outright investors Judy Ho and others for whom convertibles may form an integral component of their investment +44 (20) 7773 9682 strategies. It may also serve as useful supplementary material for anyone new to [email protected] convertibles or who has been out of the market for some time. Convertible Bond Sales Karam Deol For further information on convertible bonds and related products, and on the services +44 (20) 7773 8320 provided by Barclays Capital, please visit our website at www.barcap.com/cbonds. [email protected] Alan Welch +44 (20) 7773 8320 [email protected] James Bainbridge +44 (20) 7773 8320 [email protected] Omar Mazhar +44 (20) 7773 8320 [email protected] Table of Contents Introduction .................................................................................................................. 3 Terms and Definitions ................................................................................................. 4 Terms.............................................................................................................. 4 Definitions ....................................................................................................... 5 Sensitivities..................................................................................................... 5 Sample Termsheet ......................................................................................... 5 Example Convertible Bond Structure ............................................................. 6 Payoff and Valuation Profile ....................................................................................... 7 The Convertibles Market and New Issuance............................................................. 8 Sector, Currency and Geographic Profile....................................................... 8 Issuance Data for Year 2001.......................................................................... 8 Why Issue Convertibles?................................................................................ 8 New Issue Trade-off: Premium Vs Yield....................................................... 10 Who Buys Convertibles and Why? ............................................................... 11 Key Features and Sensitivities................................................................................. 14 Conversion.................................................................................................... 14 Calls.............................................................................................................. 14 Puts............................................................................................................... 14 Sensitivities Summary .................................................................................. 14 Traditional Valuation Models.................................................................................... 16 Bond Plus Option / Warrant Model ............................................................... 16 One-Factor Models: Stock Price................................................................... 16 Binomial Trees.............................................................................................. 17 Issuer Credit Risk ......................................................................................... 19 Optimisations ................................................................................................ 23 Binomial Versus Trinomial Trees.................................................................. 24 Finite Difference Methods............................................................................. 24 Advanced Valuation Models ..................................................................................... 27 Problems with Traditional Models................................................................. 27 Quasi-Two-Factor Models: Stock Price-Dependent Credit Spreads............ 28 Two-Factor Models: Stock Price and Credit Spreads .................................. 32 Interest Rates and Exchange Rates............................................................. 32 Firm Valuation Models.................................................................................. 33 Summary..................................................................................................................... 34 Appendix..................................................................................................................... 35 2 Convertible Bonds Research Barclays Capital Introduction In this section, we highlight the key features of convertible and exchangeable bonds, noting the salient points for valuation of these securities. A convertible or • A convertible bond is a corporate bond that is (irrevocably) convertible at the exchangeable bond is holder’s option into a specified number of equity shares, whereas an convertible into equity exchangeable bond is convertible into shares of a different corporate entity. at the holder’s option, • Hence, a convertible bond may lead to the issuance of shares and dilution of may be called by the the underlying equity whereas exchangeable bonds are non-dilutive because issuer, put by holders, the bondholder would convert into existing shares held by the issuer of the and possess a variety bond. of other features • The holder of a convertible bond is effectively long an American call option on the underlying shares. To exercise this option, the holder surrenders the future fixed cash flows of the bond rather than paying a cash strike price. • Exchangeable bondholders may also have an option on the issuer’s credit in that converting into shares may be optimal if the issuer’s credit weakens sufficiently. • The issuer may ‘call’ the bond for early redemption after a certain period (the ‘non-call’ protection period), at a specified price (or redemption yield). Callability may also be conditional, e.g. on the underlying share price exceeding certain ‘trigger’ (or ‘hurdle’) levels for some period of time. Calls tend to restrict the holder’s upside, as exercise of a call option terminates the life of the convertible and often effectively forces the holder to convert into shares. • In some issues, the holder may ‘put’ the bond for early redemption to the issuer at certain future dates, at a specified price (or yield). Unlike issuer calls, holder puts tend to occur on specific dates and offer holders some downside protection. • The bond may be in a different currency to the underlying shares, in which case the holder is also effectively long an exchange rate option (like a ‘compo’ option). • Valuation and sensitivity profiles for convertible and exchangeable bonds reflect these various options and other structural features of the individual security. • Convertibles are examples of ‘hybrid’ securities, with both debt and equity characteristics. This impacts accounting and capital management strategies. • The terms of a convertible are complex and are described in detail in its offering circular (‘prospectus’). This document may be hundreds of pages long, although the key descriptions of the structure are contained in the first few pages. We have over 530 prospectuses available on our website at www.barcap.com/cbonds. Barclays Capital Convertible Bonds Research 3 Terms and Definitions Details of terms are This section summarises the main terms of a convertible bond as outlined in an initial complex and are found term sheet and described in more detail in the subsequent prospectus. Following the in the offering circular terms are some widely used definitions in convertible bond analysis, an example of a term sheet and a diagrammatical example of a typical convertible bond structure. Terms • Bond terms: currency; issue date, size and price; par amount; maturity date; coupon rate, frequency and day-count convention; redemption yield (yield to maturity/put/call) or redemption price, etc. • Conversion terms: start and end dates (which are usually shortly after issue date and shortly before maturity, respectively); conversion ratio or number of shares per bond, (usually fixed, but often adjustable for corporate actions such as stock splits, rights issues, etc, or if there are conversion ratio resets); conversion price, which is inferred from the conversion ratio (see below). • Call terms: start and end dates of the period when the issuer may redeem the bond (usually a few years post-issue through to maturity); call price
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