Convertible bond

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In finance, convertible or conversion records or conversion debt (or convertible debenture if having more than 10 years) is a type of bond that the holder can change into the number of ordinary shares specified in the issuing company or cash of equal value. This is a hybrid security with features like debt and equity. It originated in the mid-19th century, and was used by early speculators such as Jacob Little and Daniel Drew to match the cornering market.

Convertible bonds are most commonly issued by companies with low credit ratings and high growth potential. Convertible bonds are also considered as debt guarantees because the company agrees to provide fixed or floating rates as they do in common bonds for investors' funds. To compensate for additional value through the option to convert bonds into shares, convertible bonds typically have lower coupon rates than similar, non-conversion debt. Investors receive the potential to increase conversion to equity while protecting the downside with cash flow from coupon payments and principal repayments at maturity. These properties naturally lead to the idea of ​​convertible arbitration, in which long positions in convertible bonds are balanced by short positions in the underlying equity.

From the publisher's perspective, the main benefit of raising money by selling convertible bonds is a reduction in cash payments. The advantage for companies that issue convertible bonds is that, if bonds are converted into shares, corporate debt disappears. However, in exchange for interest payments reduced, the value of shareholders' equity decreases due to the expected dilution of shares when bondholders convert their bonds into new shares.

Convertible records are also a vehicle that is often used to invest in startup companies, as a form of debt that converts into equity in future investment rounds. It is a hybrid investment vehicle, which carries (limited) debt protection at the start, but shares in upside as equity if startup succeeds, while avoiding the need to assess the company at an early stage.

Video Convertible bond

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Underwriters have been quite innovative and provide some variety of initial conversion structures. Although there is no formally clear classification in financial markets, it is possible to segment the convertible universe into the following sub-types:

vanilla convertible bond

• Vanilla convertible bond is the simplest convertible structure. They give the holder the right to convert into a number of shares determined according to the predetermined conversion price. They may offer regular coupon payments during the security period and have a fixed due date in which the nominal value of the bonds can be redeemed by the holder. This type is the most common type of convertible and typically provides asymmetric return profiles and positive convexity that are often wrongly attributed to the whole asset class: at maturity the holder will indeed convert into a share or request a redemption at face value depending on whether or not the stock price in over the conversion price.

Mandatory conversion

• Compulsory conversions are common variations of the vanilla subtype, especially in the US market. The mandatory conversion will force the holder to convert into a share at maturity - hence the term "Obligatory". The securities will very often bear two conversion prices, making their profile similar to the "risk reversal" option strategy. The first conversion price will limit the price at which the investor will receive the equivalent of its nominal value back in stock, the second will limit where the investor will get more than nominal. Note that if the stock price is below the first conversion price, the investor will experience a capital loss compared to the initial investment (excluding potential coupon payments). Compulsory conversions can be compared to selling equity forward at a premium price.

Revert the conversion

• Reverse convertibles are less common variations, mostly synthetically expelled. They will be the opposite of the vanilla structure: the conversion price will act as a short-call option: when the stock price falls below the conversion price, the investor will begin to expose the underlying stock performance and no longer be able to exchange it in par bond. This negative convex will be compensated for regular regular high coupon payments.

Packaged conversions

• Convertible packaging or sometimes the "option bond" structure is just a straight line and a shared call/letter option. Typically investors will be able to swap legs separately. Although preliminary results are similar to regular vanilla, Convertible Packaged will then have different dynamics and risks associated with them because at maturity the holder will not accept cash or stock but cash and potentially some shares. They will for example lose the modified duration mitigation effect usually with a vanilla plain convertible structure.

Maps Convertible bond

Additional features

Any structure of a convertible bond, of a kind, will bear a number of additional features as defined in its publishing prospectus:

• Conversion price: The nominal price per share at which the conversion took place, this amount is set at the time of issue but may be adjusted to the specific circumstances described in the publishing prospectus (eg Underlying shareholding). You can have more than one conversion price for non-vanilla convertible issuance.
• Premium issuance: The difference between the conversion price and the stock price at the time of issue.
• Conversion rate: The amount of the share of each convertible bond converted to. This can be expressed per bond or per cent (per 100) basis.
• Maturity/redemption date: The last payment date of the loan or other financial instrument, at which time the principal (and all remaining interest) must be paid. In some cases, there is no maturity date (eg Continuous), this is often the case with preferred converters (eg US0605056821).
• Last conversion date: End date when holder can request conversion to share. May be different from the date of redemption.
• Coupon: Periodic interest payments are paid to the convertible bondholders of the issuer. Can be fixed or variable or equal to zero.
• Outcome: The proceeds of the convertible bonds at the date of issue, may differ from the value of the coupon if the bond offers a redemption premium. In that case, the result value determines the premium redemption value and the redemption value of the intermediate put.

Convertibles may contain other technical features depending on the needs of the publisher:

• Call feature: The publisher's ability (on some bonds) to call the bond earlier for redemption. This should not be misconstrued as call option. Softcall will refer to the call feature where the issuer can only call in certain circumstances, usually based on the performance of the underlying share price (eg the current share price is above 130% of the conversion price for 20 days out of 30 days). The Hardcall feature does not require special circumstances beyond the date: the case publishers will be able to withdraw some or all of the issuance at the Call price (usually par) after a certain date.
• Enter feature: The ability of the bondholder (lender) to force the issuer (the borrower) to repay the loan at a date earlier than the due date. This often happens as a window of opportunity, every three or five years and allows the holder to exercise their right to early repayment.
• Contingent Conversion (aka CoCo): Limit the ability of convertible bondholders to convert into equity. Typically, the restrictions will be based on the underlying share price and/or time (for example, it can be converted quarterly if the stock price is above 115% of the conversion price). Reverse convertible in that regard can be seen as a variation of Mandatory which contains contingent based conversion features. Recently some CoCo publishing has been based on a Tier-1 capital ratio for several major bank issuers.
• Reset: The conversion price will be reset to the new value depending on the underlying stock performance. Typically, it will be in a bad performance case (eg If the stock price after a year is below 50% of the conversion price, the new conversion price is the current stock price).
• Change of control events (aka Ratchet): The conversion price will be re-adjusted in the event of a takeover on the underlying company. There are many subtypes of the ratchet formula (eg, Make-whole basis, depending on time...), the impact on bondholders can be small (eg ClubMed, 2013) to significant (eg Aegis, 2012). Often, this clause will also provide the ability for convertible bondholders to "place" the request for early repayment of their bonds.

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Structure and terminology

Due to their relative complexity, convertible bond investors may refer to the following conditions when explaining convertible bonds:

• Parity: The immediate value of the convertible if converted, usually obtained as the current stock price multiplied by the conversion rate stated for the base 100. It may also be known as the Exchange Property.
• Ground floor: The value of a fixed income element of a convertible that does not consider the ability to convert into equity.
• Premium: Set as current conversion price minus parity
• The exchange rate: The convertible bonds under which the issuing company and the underlying stock company are different companies (eg XS0882243453, GBL to GDF Suez). This distinction is usually made in terms of risks of equity and correlated credit risk: in some cases the entity will be legally different but not regarded as the same underwriter as the underlying stock company (eg typical in this case Sukuk, Islamic convertible bonds , requires special legal arrangements to conform to Islamic law).
• Synthetics: synthetically structured convertible bonds issued by investment banks to replicate conversion payments on specific bonds. Most inverted convertibles are synthetic. Please note that Packaged Convertibles (eg Siemens 17 DE000A1G0WA1) is not considered as synthetic because the publisher will not be an Investment Bank: they are merely acting as underwriters. Similarly, replicated structures using straight ties and options will be considered packet structures.

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Market and Investor profile

The global convertible bond market is relatively small, with about 400 billion US dollars (as of January 2013, excluding synthetics), as a comparison of direct corporate bond markets would be about 14,000 billion US dollars. Among the 400 billion, about 320 billion US dollars is the convertible bond "Vanilla", the largest sub-segment of the asset class.

Conversions are not evenly distributed and some minor differences exist between different regional markets:

• North America: About 50% of the global convertible market, mostly from the US (even if Canada is well represented in the Materials sector). This market is more standardized than others with a relatively uniform convertible structure (eg, Make-Whole Standard takes over feature, Contingent Conversion @ 130%). Regarding trade, the American convertible market is "centered" around TRACE that helps in terms of price transparency. One other specificity of this market is the importance of Mandatory and Preferable Conversions primarily for Finance (approximately 10-20% of publications in US regional benchmarks). Most of the trading operations are based in New-York.
• EMEA: European, Middle Eastern and African publications usually trade outside Europe, London being the largest node followed by Paris and to a lesser extent in Frankfurt and Geneva. It represents about 25% of the global market and shows greater diversity in terms of structure (eg from CoCoCo to French OCEANE). Due to the lack of standardization, it is often considered more technical and unforgiving than the American market from a trading perspective. Very small volume amounts are traded on the exchange, while most OTCs are done without a price reporting system (eg, like TRACE). Liquidity is significantly lower than in the North American market. Non-uniform trade provisions: French convertibles will trade in gross units while other countries will trade cleanly in equivalent equations.
• Asia (ex Japan): This area represents about 17% of the total market, with an overall structure similar to the EMEA market though with more standardization throughout the publication. Most trades are made in Hong Kong with small portions in Singapore.
• Japan: This region represents about 8% of the total market in January 2013 despite being in the past comparable to the size of the North American market. This is largely shrinking because the low interest environment makes the competitive advantage of lowering coupon payments less attractive to issuers. A key specificity of the Japanese market is the offering price of a publication that is generally above 100, meaning investors will effectively bear negative results to benefit from the potential underlying equity increase. Most of the trade is done from Tokyo (and Hong-Kong to some international companies).

Investor convertible bonds fall into two broad categories: Investors are protected and long term.

• Hedged/Arbitrage/Swap Investors: The exclusive trading desk or hedge fund uses the Arbitrage Conversion core strategy which consists of, for its most basic iteration, as the length of the convertible bond while shortening the underlying stock. Buying a convertible when selling a stock is often referred to as "on swap". Shielded investors will modulate their different risks (eg Equity, Credit, Interest Rate, Volatility, Currency) by placing one or more hedges (eg Short Shares, CDS, Asset Swaps, Options, Future). Inherently, market makers are shielded investors because they will have trading books during the day and/or last night held by hedging ways to provide the liquidity necessary to pursue their market-making operations.
• Long-only/Outright Investors: Convertible investors who will have bonds for their asymmetric payment profile. They will usually be exposed to various risks. Please note that Global convertible funds will usually hedge their currency risks as well as interest rate risk on several occasions, but Volatility, Equity & Credit hedging will usually be excluded from the scope of their strategy.

Differences between investors differ across regions: In 2013, the US region was dominated by Hedged Investors (about 60%) while EMEA was dominated by Long-Only investors (about 70%). Globally, disunity is about a balance between two categories.

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Assessment

See also: Bond Option # Embedded option; Lattice model (financial) #Hybrid Securities.

In theory, the market price of a convertible bond should not fall below its intrinsic value. The intrinsic value is the number of shares converted at par value multiplied by the current market price of the common stock.

The three main stages of bond conversion behavior are:

• In-the-money: The Conversion Price is & lt; Price Equity.
• At-the-money: Conversion Price = Equity Price.
• Out-the-money: The Conversion Price is & gt; Price Equity.

In-the-money CB is considered to be within Area of ​​Equity (right side of the diagram). At-the-money CB is considered to be within Area of ​​â € <â € (the center of the diagram). Out-the-money CB is considered to be within the Area of ​​Debt (left side of the diagram)

From an assessment perspective, convertible bonds consist of two assets: bonds and warrants. Assessing a conversion requires assumptions

1. the underlying stock volatility to assess options and
2. a credit spread for a portion of fixed income that takes into account company credit profile and convertible rank in capital structure.

By using a convertible market price, one can determine implied volatility (using spread assumptions) or implied spreads (using volatility assumptions).

This volatility/credit dichotomy is a standard practice for assessing convertibles. What makes convertibles so appealing is that, except in the case of exchange (see above), one can not completely separate the volatility of the credit. Higher volatility (a good thing) tends to accompany weaker credit (bad). In the case of exchange, the issuer's credit quality can be separated from the underlying stock volatility. The real convertible and exchange artists are the ones who know how to play this balancing act.

A simple method of calculating a convertible value involves calculating the present value of future interest and principal payments with the cost of debt and adding the present value of the warrant. However, this method ignores certain market realities including stochastic and credit spread rates, and does not take into account popular conversion features such as publisher calls, investor placements, and conversion rate adjustments. The most popular models for convertible ratings with this feature are the different models as well as the more common binomial and trinomial trees.

Since 1991-92, most market makers in Europe have used binomial models to evaluate convertibles. Models are available from INSEAD, Canada Trend Data, Bloomberg LP and from self-developed models, among others. These models require credit spread input, price volatility (frequent historic volatility), and risk-free returns. Binomial calculations assume there is a bell-shaped probability distribution for future stock prices, and the higher the volatility, the more flat is the bell shape. Where there is a call the issuer and the investor puts, this will affect the expected optional remaining period, at different stock price levels. The binomial value is the expected value, (1) taking the reading of all the different nodes of a lattice widening from the current price and (2) calculating the various periods expected from the expected residual opalization at different stock price levels. See Lattice (financial) #Hybrid Securities model. The three largest areas of subjectivity are (1) the level of volatility used, due to unstable volatility, and (2) whether or not to incorporate into the stock borrowing cost model, for hedge funds and market makers. The third important factor is (3) the dividend status of the equity that is sent, if the bond is called, because the issuer can adjust the time of the bonds to minimize the cost of dividend to the issuer.

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Usage for investor

• Generally published betel bids offer higher yields than can be earned on shares in which bonds are converted.
• Convertible bonds are safer than preferred or common stocks for investors. They provide asset protection, because the value of convertible bonds will only fall to the value of the bond floor: but in reality if the stock price falls too much the credit spread will increase and the bond price will fall below the bond floor. At the same time, convertible bonds may provide a high possible return on equity.
• Also, convertible bonds are usually more unstable than ordinary shares. Indeed, a convertible bond behaves like a call option. Therefore, if C is the call price and regular S share then

${\ displaystyle \ Delta = {\ frac {\ delta C} {\ delta S}} \ Rightarrow \ delta C = \ Delta \ times \ delta S. }$

Source: Bloomberg

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See also

• Convertible preferred stock
• Convertible security
• Enforced security
• Equity related note
• The exchange rate

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References

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External links

• Term Sheet Generator Term Sheet from Wilson Sonsini Goodrich & amp; Rosati
• Pricing of Convertible Bonds by Using Partial Differential Equations - by Lucy Li
• Determination of Inflation Bond-Indexed Convertible Bonds - by Landskroner and Raviv
• Conversion Bonds in Wikinvest
• Harvard i-lab | Financing Foundation and Capital Raising for Startups. Describes both convertible debt and simple form of convertible debt called SAFE (Simple Agreement for Future Equity)

Source of the article : Wikipedia