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Convertible Basics
- 1. Convertible Bonds –The Product POPS Follow-up Presentation 17 November 2003 Martin Haycock (+44-20-7568 2282)
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- 3. Convertible versus straightbond Straight bond Pay 100 ... ... get 5% coupon each year ... ... get 100 back Convertible bond Pay 100 ... ... get 3% coupon ... CHOICE: ... get 100 back or take 10 shares 3080381l.ppt 2
- 4. Terminology explained Conversion ratio Nominal amount Conversion Conversion 10 shares per bond ratio price Number of shares into which each ÷ = bond converts €100 10 shares €10 Parity Conversion Today’s Parity 80% x = ratio share price Value of shares 10 €8 80% underlying bond Premium 25% Conversion Today’s Premium Amount paid price share price = + above today’s share price €10 €8 25% 3080381l.ppt 3
- 5. Convertible becomes equityif share rises 140 Bond issued at 100 on 25% premium Bond price Bond price / parity Parity 100 Premium 80 50 Launch Year 1 Year 2 Year 3 Year 4 Year 5 3080381l.ppt 4
- 6. Convertible becomes abond if share falls 140 Bond trends to 100 assuming issuer not going bust Bond price / parity 100 Bond price 80 Conversion value Premium 50 Launch Year 1 Year 2 Year 3 Year 4 Year 5 3080381l.ppt 5
- 7. Convertible payoff Distressed Bond Hybrid Equity CB value Bond floor Equity value Stock price 3100356L.ppt 6
- 8. It works inreality too... 300 250 200 (%) 150 100 50 0 Nov-98 Jan-00 Mar-01 May-02 Parity FT 2% 2004 3080381l.ppt 7
- 9. Convertibles—two ways tothink of them Bond + Call Stock + Put 100 Option value Conversion premium 80 60 (%) Bond value Conversion value 40 (parity) 20 0 Bond “floor” moves with credit spread and interest rates, parity moves with the stock price 3080381l.ppt 8
- 10. Convertible termsheet—checklist Maturity Status / ranking Denomination Issue price Coupon Redemption price Conversion Conversion ratio Conversion price premium Issuer call Investor put Exchange property 3080381l.ppt 9
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- 12. The spectrum ofproducts Convertibles can be debt-like or equity-like Equity Mandatories Reset Conventional Premium redemption Debt 3080381l.ppt 11
- 13. Premium redemption convertibles ♦Price to buy convertible remains at 100 ♦ Conversion ratio stays at 10 shares ♦ Zero coupon ♦ But backload missing interest payments to maturity Pay 100 ... ... no coupon ... ... get 120 or 10 shares (should be 3%) 3080381l.ppt 12
- 14. As well asconvertibles, look out for … ♦ Issued by Company A (credit risk) Exchangeables ♦ Converts into shares of Company B (equity risk) ♦ E.g. News Corp. into BSkyB ♦ Guaranteed conversion into stock ♦ Very equity-like as no downside protection Mandatories ♦ Pay high coupon, e.g. DT 6.50% ♦ Often exchangeable, e.g. Suez / Fortis, FT / STM 3080381l.ppt 13
- 15. Modelling a CB Inputs for bond value Inputs for option value ♦ Maturity ♦ Assumed volatility ♦ Issue price ♦ Dividend forecasts ♦ Coupon ♦ Stock price ♦ Redemption price ♦ Conversion premium / price ♦ Discount rate ♦ Call features — interest rates — credit spread How to value prospectus risk / screws? 3080381l.ppt 14
- 16. CB valuation—outputs “Simpler” outputs Model outputs ♦ Premium ♦ Theoretical value — % difference between CB — What CB is “worth” if price and parity inputs and model hold true ♦ Bond value ♦ Delta — Discounted bond cash flows — Indicates equity short ie ignores equity option hedge ratio ♦ Yield-to-maturity ♦ Implied volatility — Rate of return of bond — Measure of “cost” of equity cashflows option “Cheap” and “Rich”are a matter of opinion … thus making a market 3080381l.ppt 15
- 17. Implied volatility ♦ Mostinputs for pricing are straightforward — e.g. coupon, premium ♦ Some require some estimation — dividends — credit spread ♦ But the most disputed input is volatility — discount to historic volatility — volatility levels of comparable issues ♦ Once volatility is input, model calculates theoretical value (TV) of CB ♦ Because inputs are so subjective market convention is to use implied volatility 3080381l.ppt 16
- 18. Implied volatility Implied volatility ♦ With all other variables fixed, what input volatility gives theoretical value equal to issue price? Worked example ♦ With input vol of 25, TV = 102.6 ♦ Assume Tau = 0.65 ♦ Implied volatility = 25 – 102.6 – 100.0 = 21.0 0.65 For outstanding issues, implied volatility relates to current trading price 3080381l.ppt 17
- 19. Bond floor—worked examples Workedexample 1 ♦ Discount rate 6%, CB coupon 4%, 5-year maturity ♦ What is bond value? 4 + 4 + 4 + 4 + 104 = 91.57 (1.06) (1.06)2 (1.06)3 (1.06)4 (1.06)5 Worked example 2 ♦ Discount rate 7%, 3-year maturity ♦ What is coupon needed to get bond value of 90? c + c + 100+c = 90 (1.07) (1.07)2 (1.07)3 c = 3.19% (or approximately 3.25%) 3080381l.ppt 18
- 20. Issuer call feature Powerfultool for issuers to force conversion ♦ 5 year convertible with call after three years ♦ Issuer can redeem bonds early in 30 days’ time (at 100%) ♦ If parity above 100% investors would rather convert ♦ Soft call: — bonds only callable if parity above e.g. 130% — helps issuers extract better value from investors — 30 day share price risk means some cushion needed anyway 3080381l.ppt 19
- 21. Rules of thumb—callfeature ♦ 5-year maturity with NC3 (130%) most common today ♦ Why have a trigger? — improves other terms versus unconditional call — pragmatic “cushion” required to exercise unconditional call over 30 days, so might as well have trigger ♦ Call timing — investors are wary of calls less than three years — investors could lose a lot of option value if exercised — but they may be key to meeting issuer’s needs 3080381l.ppt 20
- 22. Rules of thumb—premiumredemption ♦ Yield to maturity 50bp more than conventional ♦ Premium unchanged ♦ Why? — premium redemption less likely to convert — investor needs compensation for lower option value — investor needs compensation for lost coupon income Zero coupon ♦ May need even more yield ♦ May need lower premium ♦ Dividend income loss effects more pronounced 3080381l.ppt 21
- 23. Rules of thumb—puts ♦One-time option ♦ Allows investor to get money back before maturity ♦ Effectively shortens maturity ♦ Investors value to put date not maturity ♦ Smoke and mirrors tactic by banks — give issuer and investor maturities they want — long dated zero coupon deals issued at a discount – e.g. Roche “US$3 billion” deal only raised US$1.2 billion 3080381l.ppt 22
- 24. A CB isnot a bond plus warrants ♦ Can a CB be valued as a bond plus a call option? ♦ Whilst similar, the two are not the same — investor bases different — “usability” i.e. floating strike option — warrants not callable ♦ CB pricing software more complex than Black-Scholes 3080381l.ppt 23
- 25. The Greeks ♦ Change in theoretical value for +1% change in stock Delta ♦ Dictates stock to sell short to neutralise equity risk ♦ Typically 50–70% at issue ♦ Change in Delta for +1% change in stock Gamma ♦ Positive number—Delta increases as stock rises ♦ Change in theoretical value for +1% change in volatility Tau / ♦ Typically around 0.70 Vega ♦ e.g. 20% vol = 101.4% TV 21% vol = 102.1% TV 3080381l.ppt 24
- 26. Contact information Martin Haycock Headof Convertibles Marketing Tel: +44-20-7568 2282 email: martin.haycock@ubs.com Web pages: www.ubs.com Bloomberg: UCBR,UCBI,UCBP Reuters: CBMENU UBS Limited 1 Finsbury Avenue London, EC2M 2PP Tel: +44-20-7567 8000 www.ubs.com UBS Investment Bank is a business group of UBS AG UBS Limited is a subsidiary of UBS AG. 3080381l.ppt 25
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United States: These materials are distributed by UBS Securities LLC or UBS Financial Services Inc., subsidiaries of UBS AG, or solely to US institutional investors by UBS AG or a subsidiary or affiliate thereof that is not registered as a US broker-dealer (a "non-US affiliate"). Transactions resulting from materials distributed by a non-US affiliate must be effected through UBS Securities LLC or UBS Financial Services Inc. Canada: These materials are being distributed in Canada by UBS Securities Canada Inc., a subsidiary of UBS AG and a member of the principal Canadian stock exchanges & CIPF. Hong Kong: The materials relating to equities, corporate finance and other securities business, and related research, are being distributed in Hong Kong by UBS Securities Asia Limited. The material relating to foreign exchange, fixed income products and other banking business, and related research, are being distributed in Hong Kong by UBS AG, Hong Kong Branch. 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