Overview of Convertible Evaluation: The Basics
This chapter presents an overview of convertible securities. We introduce the basics of convertible valuation factors, with more detail to follow in subsequent chapters.
Convertible evaluation involves numerous, complicated mathematical equations. The hybrid nature of a convertible bond lends itself to the use of various equity and fixed income techniques to analyze a convertible security. Before we begin to delve into that process in detail, it will be useful to review some of the most important principles as well as definitions. Convertible securities consist of debt instruments (bonds or debentures) or preferred stock of a corporation that may be exchanged at the holder's option for a specified number of shares of the common stock over a specified time period under terms defined by the issuing corporation at the time of the security's issuance.
Introducing Convertible Securities
Convertible securities are relatively simple in concept: A convertible bond is a regular corporate bond that has the added feature of being convertible into a fixed number of shares of common stock. Conversion terms and conditions are defined by the issuing corporation at issuance. (A convertible security may also be preferred stock, but convertibles are best understood by studying convertible bonds.)
Convertible bonds are a specific type of corporate bond issued by corporations but having the same characteristics as other bonds. The actual terms can vary significantly, but the bond pays a fixed interest rate and has a fixed maturity date. The issuing company guarantees to pay the specified coupon interest, usually semiannually, and the par value, usually $1,000 per bond, upon maturity. Like other nonconvertible bonds, a corporation's failure to pay interest or principal when due results in the first step toward company bankruptcy. Therefore, convertible bonds share with nonconvertible bonds the feature that bond investors consider most precious: principal protection.
Convertibles are senior to common stock but may be junior to other long term debt instruments. Convertibles have one important feature that other corporate bonds do not have: At the holder's option, the bond can be exchanged for the underlying common stock of the company. This feature completely changes the investment characteristics of the bond.
Convertible bonds are governed under the Trust Indenture Act of 1939. The bond indenture associated with each convertible bond offering is designed to control the conflicts of interest between the shareholders of a company and its bondholders. The terms of the covenants to any individual bond indenture are an important part of it, and violation of such covenants can lead to a technical default. Specific covenants apply to seniority, call provisions, sinking fund requirements, restrictions on sale/leasebacks of assets, limitations of shareholder distributions (dividend restrictions), and debt limitation.
The convertible bond has three main parts: Its value as a straight bond, called the investment value; its value as a stock, called the conversion value; and the theoretical fair value. The investor must dissect the convertible security to understand the valuation process. The three factors are interdependent, and each must be considered for a proper valuation of a convertible security. In this chapter we begin the process of evaluating convertibles by dissecting the convertible bond into its various parts.
The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.
Past performance is no guarantee of future results.