Convertible Bonds
Topics Covered
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Bond Terminology
The Bond Contract
Convertible Bonds
The Value of a Convertible at Maturity
Forcing Conversion
Why Do companies Issue Convertibles?
Valuing Convertible Bonds
Bond Terminology
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Foreign bonds - bonds that are sold to local
investors in another country's bond market
Yankee bond- a bond sold publicly by a foreign
company in the United States
Samurai - a bond sold by a foreign firm in Japan
Eurobond market - when European and American
multinationals are forced to tap into international
markets for capital
Global Bonds - very large bond issues that are
marketed both internationally (that is, in the
eurobond market) and in individual domestic markets
Bond Terminology
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Indenture or trust deed - the bond agreement
between the borrower and a trust company
Registered bond - a bond in which the Company's
records show ownership and interest and principal
are paid directly to each owner
Bearer bonds - the bond holder must send in
coupons to claim interest and must send a certificate
to claim the final payment of principal
Accrued interest - the amount of accumulated
interest since the last coupon payment
Coupon – the annual or semiannual interest paid on
a bond
Bond Terminology
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Debentures - long-term unsecured issues on debt
Mortgage bonds - long-term secured debt often
containing a claim against a specific building or
property
Collateral trust bonds - Bonds secured by common
stocks or other securities that are owned by the
borrower
Equipment trust certificate - Form of secured debt
generally used to finance railroad equipment. The
trustee retains ownership of the equipment until the
debt is repaid.
Bond Terminology
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Sinking fund - a fund established to retired debt
before maturity
Callable bond - a bond that may be repurchased by
the firm before maturity at a specified call price
Puttable bond – A provision that allows the
bondholder to demand immediate payment. This is
the central feature in loan guarantees issued by the
government.
Defeasance - a method of retiring corporate debt
involving the creation of a trust funded with treasury
bonds
Bond Terminology
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Restrictive covenants - Limitations set by
bondholders on the actions of the Corporation
Negative Pledge Clause - the processing of giving
unsecured debentures equal protection and when assets
are mortgaged
Poison Put - a clause that obliges the borrower to
repay the bond if a large quantity of stock is bought by
single investor, which causes the firms bonds to beat
down rated
Pay in kind (PIK) - a bond that makes regular interest
payments, but in the early years of the bonds life the
issuer can choose to pay interest in the form of either
cash or more bonds with an equivalent face value
Bond Contract
Issued by J.C. Penney
Trustee
Rights of default
Registered
Denomination
Amount issued
Issue Date
Offered
Interest
Seniority
Security
Maturity
Sinking fund
Callable
Moody's rating
Bank of America National Trust and Savings Association
The trustee or 25% of debenture holders may declare the
principle due and payable
Fully registered
$1,000
$250 million
26-Aug-1992
Issued at a price of 99.489% plus accrued interest (proceeds
to company 98.614%) through First Boston Corporation
At a rate of 8.25% per annum, payable February 15 and
August 15
Ranks pari passu with other unsecured unsubordinated debt
Not secured. Company will not permit to have any lien on its
property or assets without equally and ratably securing the
debt securities
15-Aug-2022
Annually from August 15, 2003, sufficient to redeem $12.5
million principal amount, plus an optional sinking fund of up to
$25 million
At whole or in part on or after August 15, 2002, at the option
of the company with at least 30 days, but not more than 60
days notice to each August 14 as follows: schedule inserted
here
B
Straight Bond vs. Callable Bond
What is a Convertible Bond?
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Convertible bond is a bond that may be converted
into another security at the holder’s option.
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You can think of a convertible bond as equivalent to a straight
bond plus an option to acquire common stock.
When convertible bondholders exercise this option, they do not
pay cash; instead they give up their bonds in exchange for
shares.
Conversion ratio = the number of shares into which
each bond can be converted.
Conversion price = the face value of the bond divided
by the conversion ratio
Conversion value = conversion ratio x share price
Example:
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Chiquita Brands
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February 2008 issued $200M
4.25% Convertible 2016
Convertible into 44.5524 shares
Conversion ratio 44.5524
Conversion price = 1000/44.5524 = $22.45
Market price of shares = $16.85
Lower bound of value
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Bond value
Conversion value = 44.5524 x $16.85 = $750.71
How bond value varies with firm
value at maturity
Bond value ($ thousands)
3
2
bond repaid in full
default
1
0
0
1
2
3
Value of firm ($ million)
4
5
How conversion value at maturity
varies with firm value
Conversion value ($ thousands)
3
2
1
0
0
0.5
1
1.5
2
2.5
Value of firm ($ million)
3
3.5
4
How value of convertible at maturity
varies with firm value
Value of convertible ($ thousands)
3
convert
2
bond repaid in full
default
1
0
0
1
2
Value of firm ($ million)
3
4
What we do and do not know about
convertible bond financing (please see,
Dutordoir, Lewis, Seward and Veld (2014) JCF)
The article reviews the literature on:
 The issuance motives (why firms issue
convertible bonds),
 The shareholder wealth effects (both in
the short-run and the long-run), and
 The design of convertible bonds (the
determinants of convertible securities design)
Why do companies issue
convertible bonds?
There are two dominant group of
studies
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The first group of studies perceive
convertibles as a tool to reduce agency
problems
The second group of studies perceive
convertibles as a tool to reduce adverse
selection costs
Convertible debt as a financing
mechanism to reduce agency costs
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Risk-shifting model of Green (1984):
This model focuses on potential bondholders and shareholders
conflicts of interest, arguing that a convertible bond mitigates
shareholders’ incentives to engage in high-risk, negative NPV
projects. The idea behind this model is that shareholders will
have to share any cash flows resulting from high-risk strategies
with convertible bondholders.
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Sequential-financing model of Mayers (1998):
This model considers convertibles as a tool to reduce agency
problems between managers and shareholders in the special case
where the company has a sequence of investment opportunities.
The model suggests that convertibles are more useful in reducing
security issue costs and controlling the overinvestment problem.
Convertible debt as a tool to
reduce adverse selection costs
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Risk-uncertainty model of Brennan and Kraus
(1987) and Brennan and Schwartz (1988):
This model assumes that managers and stock market investors
disagree on the risk of the firm. The high levels of risk result in the
firm having to pay a higher interest rate on straight debt. This problem
is mitigated, however, by issuing convertible bonds, because higher
perceived risk translates into a higher value of the conversion option.
Thus, while the credit portion is undervalued, the conversion option is
overvalued, resulting in a fairly priced security.
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Signaling or backdoor-equity model of Stein (1992)
This model considers that there is asymmetric information about firm
value, an equity offering announcement might signal to the market
that the firm is overvalued. Since convertible issuance is less likely to
be perceived as a signal of firm overvaluation, thereby reducing
adverse selection costs.
Empirical studies on shareholder
wealth effects of convertible bond
issues
Empirical studies in this area fall into
two broad categories:
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Short-term stock price impact of convertible
bond announcements and issuance
Long-term stock price impact of convertible
bond offering
Short-term stock price impact of
convertible bond announcements
and issuance
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Negative announcement effect (the stock price effects
of convertible debt announcements are intermediate in size between
those of straight bond and common equity announcements).
For example, Eckbo et al. (2007) report that the
announcement average ARs:
Convertible bonds is -1.82% (4 event studies),
Seasoned equity offerings is -2.22% (7 event studies),
Straight bond offerings is -0.22% (non-significant)
Negative announcement effect does not hold for all countries
(i.e. Japanese and Taiwanese convertible announcements)
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Convertible arbitrage activities induce
downward stock price pressure around
convertible bond issue dates (Loncarski et al. (2009)).
Long-term stock price impact of
convertible bond offering
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Convertible bond issuers’ stock price significantly
underperforms that of matching non-issuers over the
years following issuance (see, Lee and Loughran (1998),
Spiess and Affleck-Graves (1999), and Lewis et al. (2001)).
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Recent empirical evidence shows that controlling
for changes (declines) in systematic risk leads to less
pessimistic conclusions on stock return performance
following convertible bond issuance (see, Zeidler et al.
(2012)).
Empirical studies on the design of
convertible securities
Empirical studies in this area fall in two categories:
 A first group of articles relies on the assumption that
convertible bond design choices may be indicative of
underlying issuer motives (debt-like, hedge-like, and equitylike offerings).
 A second group of studies examines the determinants
of innovations in the design of convertible securities.
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Accounting regulations allowing issuers to obtain favorable
reported diluted EPS on security design decisions (contingent
convertibles (COCOs) are convertible bonds that can only be
converted into shares of common stock if a prespecified stock
price is reached). See, Marquardt and Wiedman (2005).
Large presence of convertible arbitrageurs as investors in
convertible bond issues.
Web Resources
www.investinginbonds.com/
www.hbs.edu/projfinportal