CB Primer GS

Analysts Peter Warren [email protected] (London) 774 5035 Scott Lange [email protected] (New York) 212-357-7922

Goldman Sachs Convertible Research

The Global Convertible Handbook


Goldman Sachs Global Convertible Securities Research Group London Peter Warren [email protected] (London) 774 5035 Arup Ganguly [email protected] (London) 774 5130

New York Scott Lange [email protected] (New York) 8902 8535

Bloomberg Type GSCB on Bloomberg


Foreword The Emergence of Convertibles as a Global Asset Class The last two years have been marked by the emergence of convertibles as a truly global asset class. Market capitalization of the universe now exceeds US$400 billion with issuance levels having risen steadily through the 1990s. However, convertibles remain something of a ‘hidden’ asset class (Figure 1) with limited interest from both institutional and retail investors. This Handbook represents a general introduction to one of the fastest growing and most attractive security classes in the financial markets. Figure 1: Securities Market Capitalization Comparisons (US$) Convertible Bond Market

400bn

Swiss Equity Market*

382bn

Australian GDP

350bn

Canadian Equity Market*

316bn

Brady Bond Market

150bn TM

* Source: FT/S&P Actuaries World Indices

and Goldman Sachs

Convertibles are hybrid securities with features of both debt and equity. As such they may appeal to both equity and fixed income investors and can be useful in fulfilling a broad array of corporate financing requirements. The last few years have been marked by a blurring of the lines between debt, convertible securities and equity with an accelerating trend to the creation of custom-made financing instruments to fill the needs of a variety of issuer types. Figure 2 highlights just a few of the most familiar structures now used. Figure 2: The Equity-linked Financing Spectrum

Source: Goldman Sachs convertible research

In this Handbook we first examine the basic characteristics of traditional (or vanilla) convertible securities before broadening our analysis to include a wide variety of convertible structures and methods of analysis.

TM

‘Financial Times / Standard & Poor’s Actuaries World Index’ is a trademark of The Financial Times Limited and Standard & Poor’s, and used under license by Goldman, Sachs & Co.


Why Focus on Convertibles? Convertibles deserve the interest of financial market professionals for several key reasons: 1. Investment Opportunities. Attractive investment opportunities have persistently arisen over the last decade in the convertible markets. 2. Issuance Opportunities. Convertibles are a uniquely flexible financing tool for issuers and are increasingly present in the portfolio of company (and government) financing alternatives. 3. Hedging and Valuation Driven Opportunities. The convertible market offers profitable opportunities for investors focused on technical valuation with both hedge funds and asset swappers being active market participants. 4. Product Proliferation. The dramatic growth and diversification of the convertible market over the last five years has led to the development of numerous new convertible structures with a broad array of applications for investors and issuers alike. 5. Retail Suitability. The three elements of principal protection, income, and equity participation make convertibles a highly attractive security class for certain types of retail investors. Using the Global Convertible Handbook The Handbook comprises three sections. In the first section (Chapters 1-8), we have compiled an extensive introduction to the global convertible markets. Among the subjects covered are: Basic convertible characteristics and behavior; Special convertible structures; Investing in convertibles; Issuing convertibles; Performance of convertibles as an asset class; and Theoretical valuation of convertibles. In the second section (Chapter 9), we have prepared market overviews of the major global convertible markets along with a directory of the largest convertibles currently outstanding. In the third section (Chapters 10-13), we include a glossary of terms and a bibliography.


In compiling the Global Convertible Handbook, we have drawn on the expertise and work of numerous of our Goldman Sachs colleagues. We highlight, in particular: Michael Abbott, Anand Aithal, Indrajit Bardhan, Mark Buisseret, Gavin Brake, Matthieu Duncan, Jiro Masuda, Michael Price, and John Rustum. Peter Warren June 1997


Table of Contents 1.

2.

3.

4.

5.

6.

Introduction to Convertible Securities

1

Description of Convertible Securities

2

Quotation and Identification

4

Basic Characteristics and Behavior

6

Call Protection and Put Options

17

Convertible Price Behavior

19

How Convertibles Behave When Stock Prices Move

20

How Convertibles Behave When Interest Rates Move

26

Other Equity-linked Structures

29

Automatically Convertible Equity Securities (ACES)

31

Convertible Quarterly Income Preferred Shares (Convertible QUIPS)

37

Credit Enhanced Debt Indexed To Stock (CrEDITS)

40

Exchangeable Structures

42

Original Issue Discount (OID) Convertible Securities

45

Reset Features

48

Yield Enhanced Stock (YES, also known as PERCS)

51

Approaches to Convertible Investment

57

Investing in Convertibles

58

Investment Scenarios

63

Convertible Specific Investment Risks

70

Stripping Convertible Bonds

72

Investing in Convertibles as an Asset Class

77

Performance of Convertibles as an Asset Class

78

Rationalizing Convertible Outperformance

88

Issuing Convertible Securities

91

The Issuer’s Perspective

92

Fulfilling Financing Objectives - Why Issue a Convertible?

95

Deciding on the Appropriate Structure

98


7.

8.

9.

Valuing Convertible Securities as Derivatives

103

Theoretical Approaches to Convertible Valuation

104

Valuing a Hypothetical Convertible

110

Convertibles in the Euromarket

115

Structure of the Euroconvertible Market

116

Convertible Market Profiles

119

Introduction to Market Profiles

120

Further Information

120

France

123

Germany

127

Hong Kong

131

India

135

Italy

139

Japan

143

Korea

155

Philippines

159

Switzerland

163

Taiwan

167

Thailand

171

UK

175

US

179

Rest of Asia/Australia

191

Rest of Europe

193

Other Emerging Markets

197

10. Glossary of Convertible Terms

199

11. Figures in Text

207

12. Select Bibliography

211

13. Appendices

213

Appendix 1: US Convertible Bond Total Returns (%) 1957-95

214

Appendix 2: Convertible Market Acronyms

215


1.

Introduction to Convertible Securities Description of Convertible Securities What is a Convertible? Convertible Bonds Convertible Preferreds Hybrids Exchangeables Quotation and Identification Convertible Bonds Convertible Preferreds Basic Characteristics and Behavior Definition of a ‘Vanilla’ Convertible Convertibles Compared to Bonds with Warrants Two Views of Convertible Securities The Convertible Graph In the Money, Balanced, Out of the Money Why do Investors pay a Premium to Own a Convertible? Simple Breakeven Advanced Breakeven Call Protection and Put Options The Call Feature Absolute (or Hard) Call Protection Provisional (or Soft) Call Protection Calling Convertibles to Force Conversion Calling Convertibles for Cash The Put Feature

1


Description of Convertible Securities What is a Convertible? A convertible is typically a fixed income-type security that is also convertible into a predetermined number of shares of the issuer. Hence its volatility and expected returns at issue are less than those of the issuer’s common stock but greater than those of its straight (non-convertible) debt. A convertible is not, however, a mere combination of a company’s equity and fixed income securities. Convertibles are a separate asset class that can uniquely meet a broad array of issuer and investor objectives. Convertibles come in four main forms: convertible bonds, convertible preferred stock, hybrids and exchangeables. Convertible Bonds A convertible bond is a fixed income obligation of a company. Each bond pays a fixed cash sum, the coupon, usually either annually or semi-annually. The issuer is also obliged to return the principal amount of its borrowings (the face value) to the bondholder at a specified redemption date or maturity if the holder so desires. Since most coupon-paying convertibles are issued at par, this obligation in effect constitutes a guarantee that investors will ‘get their money back’ if the company is solvent at the redemption date. Convertible Preferreds Convertible preferred stock typically pays a fixed dividend on a quarterly basis. The issuer’s obligation to pay this dividend lasts as long as the security remains in existence. In most cases the convertible preferred stock has no redemption date and, as with common stock, the issuer has no obligation to ever repay the proceeds from the sale of the preferred. Convertible preferred stockholders have a lower claim on the assets of the issuer than convertible debtholders. They do, however, have a claim senior to common stockholders. In the case of cumulative convertible preferreds, cash dividends can only be paid to common stockholders if all past and present dividends owed to preferred holders have been paid. In the case of non-cumulative preferreds, dividends may be paid to common stock holders as long as preferred dividends have been paid for the present period even if past preferred dividends have been omitted and remain unpaid. Convertible bonds have historically been more widely issued than convertible preferreds. Hybrids Under the umbrella of the convertible market, there are a variety of additional securities which combine elements of equity and fixed income instruments in a

2


single security. Examples include: Automatically Convertible Equity Securities (ACES), Convertible Quarterly Income Preferred Shares (Convertible QUIPS), Yield Enhanced Stock (YES), and Credit Enhanced Debt Indexed To Stock (CrEDITS). Exchangeables Instruments for which the issuer and the underlying shares are different companies are known as exchangeables. Although they share many of the attributes of convertibles, there are also significant differences and we discuss them in detail in Chapter 3.

3


Quotation and Identification Convertible Bonds For convertible bonds, prices are quoted as a percentage of the face value of the bond, exclusive of accrued interest. Thus, if a price of a convertible with a face value of $1,000 is ‘105%’, the investor pays a price of $1,050. In practice, market practitioners usually omit the word ‘percent’ when quoting a price, so the price would be quoted as simply ‘105’. The term par is often used to signify 100% of the face value. In the simplest and most common cases the issue price of a convertible is 100% of its face value. Here the term ‘par value’ becomes interchangeable with the term ‘face value’. Each unit percentage of face value is referred to by market practitioners as a point. Thus, the difference between a price of 105 and a price of par is 5 points. In addition to the quoted offer price, purchasers of convertible bonds generally have to compensate the seller for interest accrued from the time of the last coupon payment up to the sale date. The method of calculation of this accrued interest may vary between markets. In the Euroconvertible markets it is usually calculated on a 30/360 day basis. Convertible bonds are usually identified by their coupon and their maturity date. For example ‘ABC Corp. 5% of 15 March 2007’ refers to a bond issued by ABC Corp. which pays a coupon equal to 5% of the bond’s face value each year and where the principal amount of the bond is due for repayment on 15 March 2007. Sometimes the notation is shortened to ‘ABC Corp. 5% 2007’. Convertible Preferreds Convertible preferreds are typically quoted on the same basis as common stock. Thus, if a convertible preferred is quoted as being offered at $55, then this is the price actually paid by a purchaser. There is usually no concept of a purchaser paying an additional sum in respect of preferred dividends accrued since the last dividend payment date. However, as with common stocks, convertible preferreds can trade on an ex-dividend basis. Convertible preferreds are usually identified by the fixed dividend they carry. Thus, if ABC Corp. has a convertible preferred which pays a total dividend of $3 per year, then it is referred to as the ‘ABC Corp. $3 convertible preferred’. If an issuer has several different issues (or series) of preferreds (either convertible or non-convertible), then the issue may additionally be referenced by its series as ‘ABC Corp. $3 convertible preferred series B’ or, more simply, ‘ABC Corp. $3 cvt pfd B’. Rather confusingly, convertible preferred dividends are sometimes incorrectly referred to in percentage terms. Thus, ABC Corp.’s convertible preferred might be referred to as ‘ABC Corp. 6% cvt pfd B’, meaning that the fixed $3 dividend

4


represents 6% of the preferred’s original issue price of $50. Note that the ‘6%’ does not refer to the actual yield on the preferred in the secondary market - if the preferred’s price is $55 then the current yield (or running yield) will be 5.45% (=$3÷$55).

5


Basic Characteristics and Behavior Definition of a ‘Vanilla’ Convertible Convertibles can appear in a large number of guises, being tailored to the needs of a specific issuer or an individual market and encompassing the whole array of combinations between pure debt and pure equity. Consequently, it is difficult to formulate a precise definition that at the same time encompasses all those securities with convertible-like features. The most common approach is to consider the traditional, or ‘plain vanilla’, convertible and to evaluate variations within this framework. Whereas the borrowing company has obligations, the convertible holder has corresponding rights. Specifically, investors have the right (but not the obligation) to exchange their bond and forfeit future interest payments and redemption of principal, usually at any time (ie American-style exercise), in return for a predetermined number of shares. The number of shares receivable per bond is known as the conversion ratio. Although no cash changes hands when a convertible bond is converted, we can determine the price at which a convertible investor buys shares (the conversion price) by dividing the par value of the bond by the conversion ratio. Thus, a bond with a face value of $1,000 which can be exchanged for 100 shares effectively gives investors the right to buy shares at a conversion price of $10. Convertibles Compared to Bonds with Warrants Because convertibles have both equity and bond characteristics they are often likened to the combination of a straight bond and a warrant. A bond is a redeemable security which pays a fixed rate of interest while a warrant bears no interest or right to return of principal, but does give investors the right (but not the obligation) to buy a fixed number of shares at a fixed price during a specified period. However, the two instruments are not identical. For the bond with warrant combination (sometimes known as a bond cum warrant), investors subscribe for shares by handing in their warrants and a predetermined cash sum while the bond remains in existence. For a convertible, in contrast, the warrant is embedded within the instrument. That is to say, investors can only subscribe for the embedded warrant by submitting the whole instrument for conversion. This may be referred to as a useable bond with warrant combination. For a bond cum warrant, the decision to exercise the warrant depends on the opportunity cost of foregoing cash. For a convertible, the decision as to when to exercise is conditional upon the opportunity cost of foregoing ownership of a corporate bond. Note also that a bond cum warrants package can be (and usually is) stripped into its components and traded separately in the secondary market whereas convertibles can only trade as an unified package.

6


Two Views of Convertible Securities A convertible is part debt, part equity. The importance of these two factors in determining the overall valuation of a convertible varies according to the respective valuations placed on it by equity and fixed income investors. Equity investors can view a convertible as a combination of the following: Equity; A put option to exchange the equity for a straight bond; plus A swap to the conversion date that gives the investor bond coupons in exchange for dividends. Figure 3: The Equity Perspective on Convertibles


Fixed income investors, in contrast, can view the same convertible as a combination of the following: A straight bond; plus A call option that allows the investor to exchange the bond for equity. Figure 4: The Fixed Income Perspective on Convertibles


Typically, the price of a convertible will reflect at least the higher of the valuations ascribed to it by debt and equity investors. The Convertible Graph Figure 5 shows how the typical convertible reacts to movements in share prices in an environment of unchanging interest rates. The line labeled ‘Fixed Income Value’ represents the value of the instrument to bond investors in the absence of an equity option. This fixed income value (sometimes called its investment

7


value or bond value) will be affected by a number of factors discussed below, but in the simple analysis it is not correlated with movements in share prices. Thus, Fixed Income Value is a straight line on Figure 5. Figure 5: Basic Convertible Price Behavior


By definition, the equity value of a convertible varies with the share price because a convertible bond allows an investor to convert into a predetermined number of shares. The number of shares to which an investor is entitled per convertible is the conversion ratio. The line labeled ‘Parity’ shows the equity value embedded within the convertible. Parity is simply the share price multiplied by the conversion ratio, so it rises pro rata with the share price. Where the currency denomination of the convertible bond is different from the currency of the underlying shares, then parity is calculated by multiplying the share price expressed in terms of the bond currency by the conversion ratio (cross-currency parity). As an illustration of parity, consider ABC Corp.’s 5% 2007 convertible bond described in Figure 6. In this example assume that the bond has a face value of $1,000 and the company’s current stock price is $80. Further, assume that each convertible entitles the investor to convert into 10 shares of ABC common stock ie the conversion ratio is 10. If the holder of this convertible were to convert today, then 10 shares with a current value of $80 each would be delivered. Thus, the total value of the shares received upon conversion of one bond would be $800,

8


or 80% of the bond’s face value. Or, using the terminology of convertible market practitioners, parity is 80. Figure 6: Calculating Parity Convertible Terms Issuer

ABC Corp.

Coupon

5% semi-annual

Maturity

15 March 2007

Face Value

$1,000

Conversion Ratio

10

Current Stock Price

$80

Calculation Parity

= Stock Price * Conversion Ratio = $80*10 = $800 or 80 Points


In the Money, Balanced, Out of the Money In discussing convertible bonds, it is market convention that they are referred to with one of three designations: in the money, balanced (or at the money), and out of the money. These are drawn from the terminology of the option market and refer to the equity option embedded in the convertible. Figure 7 applies these terms to our basic convertible chart. We discuss these terms in much more detail (and introduce junk convertibles) in Chapter 2.

9


Figure 7: Market Terminology


Why do Investors pay a Premium to Own a Convertible? In principle, an equity-oriented investor ought to be willing to pay at least parity for a convertible. If a convertible trades significantly below parity then (allowing for transaction costs and foregone accrued interest) arbitrageurs would buy the convertible and convert it into shares, thereby creating a riskless profit. Parity represents the intrinsic value of a convertible to an equity investor. Likewise, a fixed income investor ought to be willing to pay at least a price where the yield to maturity on the convertible is equivalent to the yield investors would demand for a non-convertible bond which is identical in all other respects. As discussed above, a convertible consists of more than just equity and more than just a straight bond. Consequently, some investors may be willing to pay a premium over parity (the conversion premium or, simply, premium) to own a convertible while others may be willing to pay a premium (known as the risk premium) over the intrinsic investment value. Figure 8 illustrates the concept of premium. In the regions labeled ‘In the Money’, ‘Balanced’ and ‘Out of the Money’, the Parity and Fixed Income Value lines determine the lower bounds of the convertible’s price. The convertible’s value will at least lie on this boundary and in most cases the actual convertible price will be at a premium to these values. The conversion premium (or equity

10


premium) is the area between the convertible price and the parity line. The risk premium is the area between the convertible price and the fixed income value line. Figure 8: Introducing Premium


Returning to the example of ABC Corp., consider the hypothetical situation where the convertible is issued on 15 March 1997 and all the other terms of the convertible are as illustrated in Figure 9. If the convertible is issued at a price of $1,000 while the underlying shares are worth $800, then investors would pay a premium of $200 to own the convertible rather than the underlying stock. Put another way, investors pay par for something where parity is 80. This is a premium of 20 points (= 100 - 80) or, in percentage terms, a premium of 25% over parity.

11


Figure 9: Calculating Premium over Parity Convertible Terms Issuer

ABC Corp.

Coupon

5% semi-annual

Maturity

15 March 2007

Parity

80

Convertible Price

100

Calculation Points Premium

= Convertible Price - Parity = 100 - 80 = 20 Points

Percent Premium

= Points Premium ÷ Parity = 20 ÷ 80 = 25%


A similar calculation can be made for a convertible’s premium over fixed income value. The issuer must pay interest on the debt portion but not the warrant portion. Although ABC Corp. may raise $1,000 from the sale of each convertible, its interest cost is less than that from the sale of $1,000 of straight debt alone. Assume that when the convertible is issued, the yield to maturity on 10 year US Treasuries is 6.81%. Further assume that in order to hold ABC Corp.’s straight debt for 10 years, which carries some risk of default, rather than ‘riskless’ US Treasuries the market requires an additional 2% (or 200 basis points) in yield. In other words, were the company to raise straight debt the interest cost would be 8.81% rather than the 5% interest cost of the convertible. Conversely, we can view the fixed income floor of the convertible as being at 75, because at that price the yield to maturity on the convertible is 8.81%. For a convertible priced at par, the premium over fixed income value is 25 points, or 33% (Figure 10).

12


Figure 10: Calculating Risk Premium Calculations Issuer

ABC Corp.

Coupon

5% semi-annual

Maturity

15 March 2007

Investment Value

75

Convertible Price

100

Convertible Terms Points Risk Premium

= Convertible Price - Investment Value = 100 - 75 = 20 Points

Percent Risk Premium

= Points Risk Premium ÷ Investment Floor = 25 ÷ 75 = 33%


Simple Breakeven Historically, equity investors determined how much premium to pay by implicitly assuming that the convertible would eventually be converted into equity. Using this approach, a ‘fair’ premium is simply the cumulative incremental income from now until conversion that an investor would get from owning a convertible rather than an equivalent amount of equity. At issue, most plain vanilla convertibles yield more than their underlying shares. This reflects the fact that in most markets bond yields are greater than equity yields. The key valuation measure for this approach is called breakeven. This is a measure of the amount of time necessary to recover the conversion premium through the convertible’s income advantage. Although there are various measures of breakeven, the correct approach is to compare the cash premium which an investor must pay to own stock via a convertible with the additional annual income which the convertible gives compared with an investment of an equivalent amount in the underlying equity. Once calculated, investors can compare breakeven with the number of years that the convertible is guaranteed to remain in existence. Most convertibles can be redeemed by the issuer before they mature (ie the convertible is at some point callable), so investors look at breakeven relative to the time from now to the date on which the convertible first becomes callable (the first call date). From an investor’s perspective, the shorter the breakeven the better. If breakeven is within the non-call period then investors should recover the conversion

13


premium through income advantage alone. Once investors have recovered the premium, any further income advantage is effectively ‘free’. Note that when calculating breakeven, convertible investors do not typically factor in any growth or reduction in dividends (bond coupons are guaranteed, common stock dividends are not) and do not account for the time value of money in calculating cash flow advantage. In terms of our earlier example, assume that ABC Corp.’s stock has a dividend yield of 2%. Investors have a choice: either they spend $1,000 buying the convertible bond or they spend the same amount buying shares directly. Each $1,000 bond gives an annual income of $50, whereas investing this amount in ABC Corp.’s stock gives an annual income of $20. As calculated above, parity is 80, or $800 per bond. Since the investor has to pay $1,000 to own the convertible, this represents a $200 cash premium. Figure 11 demonstrates the breakeven calculation for this convertible.

14


Figure 11: Calculating Breakeven Convertible Terms Issuer

ABC Corp.

Coupon

5% semi-annual

Maturity

15 March 2007

Parity

80

Convertible Price

100

Stock Dividend Yield

2%

Premium

= 20 Points or $200 per $1,000 bond

Calculations Annual Income Advantage

= Annual income from convertible Annual income from an investment of the same amount in stock = Convertible income per bond - (Cash paid for convertible * stock dividend yield) = $50 - ($1,000*2%) = $50 - $20 = $30

Breakeven

= Number of years needed to recover convertible’s premium through its income advantage over the common stock = Cash Premium ÷ Annual Income Advantage = $200 ÷ $30 = 6.66 years


Advanced Breakeven The simple breakeven approach suffers from three main defects:

1. It does not typically factor in any change in stock dividend over the life of the instrument.

2. It is of limited use to investors who are looking at convertibles as an alternative to investing in fixed income instruments.

15


3. It does not take into account the different risk profile of convertibles relative to equities - a convertible security is more than just a yield-augmented stock substitute. A more advanced approach is therefore to use a mathematical model which aims to value explicitly the convertible’s embedded option, taking into account both income and capital flows relative to those on the stock and relative to those on a fixed income security of equivalent credit quality. This contrasts with the breakeven approach which ignores risk and capital flows and only considers income flows relative to the underlying equity. A mathematical model allows the investor to see how a convertible is valued with respect to past and present parameters (eg current interest rates, share prices, and historical volatility). However, the model is in no sense predictive. Investors who are unable to hedge those variables which affect theoretical valuations (eg share prices or interest rates) cannot substitute theoretical valuations for fundamental analysis of the underlying equities and the interest rate environment. We review in Chapter 7 the methodology for building a simple convertible model.

16


Call Protection and Put Options The Call Feature A call feature gives the issuer the right to redeem a convertible before maturity at a predetermined price. This call price is usually at par or at a small premium to par. In addition to the call price, the company must generally pay investors the amount of interest that has accrued between the previous coupon payment date and the call date. Absolute (or Hard) Call Protection The right to redeem a convertible can be valuable for an issuer and consequently it detracts from the value of the bond to an investor. Thus, to protect the investor when a convertible is first issued there is usually a period of time during which the issuer may not call the bond. This is known as absolute (or hard) call protection. Provisional (or Soft) Call Protection From the end of hard call protection until maturity, the bond is generally callable without precondition. In some cases, the bond may be callable only if the issuer’s share price trades above a certain level for a predetermined number of days such as 30 (or 20) out of 30 days. This is known as provisional (or soft) call protection. Usually the share price trigger is set between 130% and 150% of the conversion price. A bond with such a feature would be referred to as having 130% provisional call protection or 150% provisional call protection. Calling Convertibles to Force Conversion When a bond is called, investors have the right to choose whether to accept the call price or to convert into shares. In making this decision, investors will compare the call price (plus accrued interest) with parity (note that investors usually forfeit any accrued interest if they convert). Thus, if parity is above the call price, a decision to call a bond will force investors to convert into equity. This is the intention behind most call decisions - ultimate equity conversion is, after all, what most companies have in mind when they decide to issue a convertible. In practice, issuers usually try to force conversion through a call only when parity is well above the call price. This is because most convertible indentures require the issuer to give between 30 and 90 days notice of call. Investors will only make up their minds whether to convert or redeem the bonds at the last moment. Thus, during the notice period the issuer runs the risk that a share price decline might bring parity below the call price and suddenly the issuer will have to find cash instead of shares to pay off convertible bondholders. The more volatile a share price, the greater the margin of error that issuers should allow. As a rough rule of thumb, issuers usually wait until parity is 10%-15% above the call price plus

17


accrued interest before calling a bond. Securities houses may facilitate this process of calling a convertible by underwriting the call for the issuer. A company’s decision to force conversion may also be affected by other factors. Some managers may be concerned about the potential earnings dilution, although most analysts focus on fully diluted rather than primary figures. More significantly, companies with high yielding stocks may find that the after-tax cost of interest payments on the convertible is less than the (non tax-deductible) cost of paying dividends on the underlying shares and so may decide against a call. Conversely, managements that are more sensitive to balance sheet considerations may be more likely to force conversion into equity. Calling Convertibles for Cash Sometimes it may be rational for an issuer to call a bond even if parity is well below the call price. This may be the case either if interest rates fall or if the company’s credit improves in the years following a convertible issue. At issue, the coupons paid on convertible debt are less than those paid on comparable straight debt (the issuer is selling more than just a future income stream, so investors do not require equivalently high yields). However, if interest rates subsequently decline (or issuer credit quality improves) the issuer may find it profitable to redeem the convertible for cash and refinance with cheaper straight debt. This also removes a potential source of dilution. Alternatively, the company could issue a new convertible. Calls for cash redemption are much rarer than calls for conversion. This is because interest rates tend to be less volatile than stock prices and because managements tend to have a bias in favor of conversion. The Put Feature Almost all convertibles have call features, whereas put features are less common. A put feature gives investors the option to force the issuer to redeem a convertible on a predetermined date or dates prior to maturity at a predetermined price. The issuer is usually required to redeem the convertible for cash (hard put). However, some convertibles give the issuer the option of redeeming the issue with shares (soft put), as long as the market value of the shares issued is at least equivalent to a predetermined value. For a convertible which is issued at its face value, the put price will either be par (par put) or, more commonly, above par (premium put). The effect of having a put option is to increase the investment value of a convertible in that it allows holders the option to shorten maturity on the instrument. In assessing yields and fixed income value investors will typically look at the yield to put rather than the yield to maturity. The decision as to whether to exercise the put will depend on the put price relative to the value of the convertible at the put date in the absence of the put feature.

18


2.

Convertible Price Behavior How Convertibles Behave when Stock Prices Move Balanced Convertibles In the Money Convertibles Out of the Money Convertibles Junk Convertibles How Convertibles Behave when Interest Rates Move Impact of Interest Rates on Convertible Prices Interest Rates on ‘Risk-Free’ Securities Creditworthiness Callability When do Investors Convert?

19


How Convertibles Behave when Stock Prices Move Balanced Convertibles A balanced (or at the money) convertible is generally thought of as one whose price is influenced by movements in both share prices and interest rates. As a very rough rule of thumb, a noncallable bond which has three years to maturity might be considered balanced if the premium over parity was between 15% and 40% while the premium over fixed income value was between 15% and 25%. Figure 12 is the price and parity chart for the Cookson 7% 2004 convertible bond. Through the period shown, the convertible participated in much, but not all, of the appreciation of the underlying shares (AB) and then participated in some, but not all, of the subsequent share price weakness (CD). Figure 12: Cookson 7% 2004 - Anatomy of a Balanced Convertible

In the Money Convertibles In the money convertibles are those where the actual share price is above the conversion price. As share prices rise, a convertible becomes more sensitive to equity influences and less sensitive to interest rates because rising share prices increase the convertible’s parity value without increasing its fixed income value. Thus, from the perspective of an investor looking at convertibles as an alternative to a straight bond, in the money convertibles carry greater risk than out of the money issues.

20


An important consideration for investors who use convertibles as an alternative to equities is how much of the share price's upside potential the convertible will capture. This will depend on the convertible’s call protection. If an in the money bond is callable and it would be rational for an issuer to exercise that call, then investors will not be willing to pay a premium to own the convertible. Consequently, as the share price rises the premium will contract towards zero, implying underperformance (in terms of capital appreciation) relative to the stock. Indeed, it is possible for callable convertibles to trade at a discount to parity since any accrued interest will be lost if conversion is forced. Once the premium has fallen to this level, the convertible should move one-for-one with the shares on the upside. (If the discount were to get any wider there would be an arbitrage opportunity.) Figure 13 profiles the price and parity of a callable convertible bond (Michelin 2.5% 2001) through a prolonged period of share price appreciation. As the convertible approached its call price (A), premium contracted rapidly with convertible investors unwilling to pay a premium for an instrument liable to be called away from them. Figure 13: Michelin 2.5% 2001 - Anatomy of an In the Money Callable Convertible

In contrast, issues with call protection will experience less premium contraction, so the convertible produces a similar capital return plus a higher income return, thereby producing a superior total return. If a bond has hard call protection, the contraction that does take place usually reflects one of two things. It reflects either: (1) the fact that as the bond price rises with the share price the value of the embedded put option falls; or (2) a rapidly growing dividend (and hence rapidly falling income advantage).

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Figure 14 profiles price and parity for a convertible with hard call protection until 5 July 2000 (Daimler Benz 4.125% 2003). In this example, premium fell far more slowly (than in Figure 13) although eventually it did tend toward zero as the value of both the embedded put option and the incremental yield advantage diminished. Figure 14: Daimler 4.125% 2003 - Anatomy of an In the Money Non Callable Convertible

Issues with provisional call protection will experience premium contraction, but only as the share price approaches the call trigger rather than the conversion price. The practical implications of provisional call protection are therefore: Investors are guaranteed a certain amount of capital appreciation (30%-50%) before the call becomes effective; Calls only take place to force conversion; and Issuers do not need to have a margin of error when dealing with provisional call protection since parity is already at a 30%-50% premium to the call price. Out of the Money Convertibles As parity declines, the convertible’s price becomes less sensitive to the share price and more sensitive to changes in interest rates; ie the convertible’s delta (rate of change) with respect to underlying share price movements falls. This is because a decline in the convertible’s price increases the yield on the security and this in turn attracts buying support from fixed income funds (who will look at either the convertible bond’s yield to maturity or yield to call) and equity income funds (who will be interested in the running yield on a convertible bond).

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Figure 15 profiles price and parity for Korea Electric Power Company (KEPCO) 5% 2001. In this example, the convertible price has not fallen below 96 (AB) despite periods of stock price weakness (CD EF). At point B the convertible is trading out of the money with low sensitivity to stock price movements. Figure 15: KEPCO 5% 2001 - Anatomy of an Out of the Money Convertible

Note that the precise identity of the ‘buyer of last resort’ (ie the investor who provides the floor for the convertible price) will depend on the credit quality of the issuer and the shape of the yield curve. Fixed income investors who look at capital flows as well as income flows in their yield calculations are more (less) likely to buy issues trading well below (above) their redemption price. Also, fixed income funds may restrict their investment to issuers who meet certain credit quality thresholds whereas equity income funds are unlikely to face similar restrictions. As the share price falls, the value of the convertible’s embedded option falls. Ultimately, this equity call option can be worth so little that the convertible will trade purely as a straight bond. At this point, the convertible's valuation will be governed by the same factors as those which would influence a similar corporate straight bond. Junk Convertibles The assumption that a convertible price has a ‘floor’ depends on the market’s continuing faith in an issuer’s ability to meet its interest and principal repayment obligations. If the market’s faith is shaken, then investors will demand a higher yield (and hence lower price) to induce them to hold the bond. Figure 16 redraws the earlier Figure 5 to account for junk convertibles.

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Figure 16: Junk Convertibles – The Investment Floor ‘Disappears’


Thus, fixed income value can become a moving target which varies with investor sentiment. This is particularly true for companies perceived to be in financial distress. The same investor sentiment should lead simultaneously to a fall in the issuer’s share price since in any liquidation of the company shareholders will have a lesser claim on any remaining assets. Thus, although there is no causal link between the two, in practice bondholders can use low and rapidly declining share prices as an indicator of falling credit quality. In the event of a default or liquidation of the issuer, the ultimate floor for the bond price will depend on the amount of funds available to meet the claims of convertible holders.

24


Figure 17 profiles price and parity for a junk convertible bond (NTS Steel 4.0% 2008). In this example, the convertible price continued to fall with the share price, reflecting a strong correlation between NTS Steel credit quality and the company’s share price. Figure 17: Anatomy of a Junk Convertible - NTS Steel 4.0% 2008

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How Convertibles Behave when Interest Rates Move Impact of Interest Rates on Convertible Prices The level of interest rates (in the convertible bond currency) can affect a convertible price for two reasons: It may have an effect on the valuation of the underlying equity (if the shares are denominated in the same currency as the bond); and It will affect the valuation of the convertible’s fixed income ‘floor’, and hence its valuation, particularly in the out of the money and junk regions. Interest Rates on ‘Risk-Free’ Securities The key determinant of a convertible’s fixed income floor will be the interest rate at which a sovereign borrower can borrow money in its own currency for any given period of time. This represents the risk-free interest rate - investors can always lend to sovereign issuers (in their own currency) with certainty of return of principal since the sovereign entity has the ability to tax or issue new currency. If the rate at which a sovereign entity can borrow changes, then other things being equal, we would expect to see an equivalent change in the interest rates the market demands from non-sovereign issuers. Creditworthiness The yield which the market demands from a corporate borrower will be greater than that demanded from a sovereign borrower, because of the risk that the company will default on its payment obligations. The difference between the actual yield on a (nonconvertible and non-callable) corporate bond and that on a risk-free sovereign bond is known as the credit spread. The size of this credit spread can vary according to the market’s perception of the risk of default and on the general availability of investors willing to assume a given level of risk. If an issuer has straight debt outstanding, it is relatively straightforward to determine the appropriate credit spread to use in determining a convertible’s bond value. In the absence of such an issue, credit analysts will use a variety of techniques to evaluate the appropriate spread, including detailed analysis of the individual company and credit spreads on issuers from comparable industries or countries. Callability Normally, investors compare the yield on a convertible with the yield on a riskfree security of equal duration plus a credit spread. However, most convertibles may be called before maturity. In these circumstances, the true bond value for a convertible will be the bond value for a non-callable, nonconvertible bond of identical maturity minus the value of the interest rate call option which the investor has ceded to the issuer. This is normally calculated using an option-

26


adjusted spread (OAS) model and is of particular use in situations where interest rates have declined significantly since a convertible was issued. When do Investors Convert? Generally investors do not convert unless the decision is forced upon them by a call notice or impending maturity. As long as the convertible remains outstanding, the investor can hold both a put (albeit one that may be far out of the money) and usually some form of income advantage. The circumstances where an investor might convert are: Arbitrage. If a convertible is trading at a discount to parity, there may be an arbitrage opportunity. Income advantage. If a convertible is deep in the money and the dividend income available on conversion exceeds the bond coupon, then investors may convert. Raising the dividend may be the only way for issuers to ‘force’ conversion of a non-callable bond.

27


28


3.

Other Equity-linked Structures Automatically Convertible Equity Securities (ACES) Introduction to ACES ACES Structure What Does the Investor Receive at Maturity? Callability Breaking Down ACES Exchangeable ACES Convertible Quarterly Income Preferred Shares (Convertible QUIPS) Introduction to Convertible QUIPS Convertible QUIPS Structure The Issuer’s Perspective Valuation and Performance Convertible MIPS Credit Enhanced Debt Indexed To Stock (CrEDITS) Introduction to CrEDITS CrEDITS Structure Exchangeable Structures Introducing Exchangeables Structure of an Exchangeable Mandatory Exchangeables Notation Privatization Exchange Notes (PENs) Original Issue Discount (OID) Convertible Securities Introduction to OID Securities Description Valuation Considerations for Issuers and Investors

29


Reset Features Introduction to Reset Features Downward Resets Upward Resets Negative Gamma Credit Correlations Yield Enhanced Stock (also known as PERCS) Introduction to Yield Enhanced Stock (YES) Description of the Structure What Does the Investor Receive at Maturity? Breaking Down YES Callability

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Automatically Convertible Equity Securities (ACES) Introduction to ACES Automatically Convertible Equity SecuritiesSM (ACES) are a mandatory convertible security also known by the acronyms DECSSM, PRIDESSM and SAILSSM. ACES are mandatorily convertible into common stock at maturity and offer investors high current income in the form of a dividend or coupon. In return for this yield enhancement, ACES investors give up part of the potential stock price appreciation in the form of a conversion premium. ACES are the most equity-like convertible security currently in the market-place. Quite simply, ACES can be thought of as stock where proportionately more of the total return comes through income and less of the total return comes through capital gains or losses. In the event of share price weakness, ACES should somewhat outperform common stock due to their enhanced yield. In the event of share price strength, ACES should slightly underperform the underlying common stock since they are convertible into it at a premium. ACES Structure ACES are high income convertible securities that mandatorily convert into common stock at maturity. As with other convertibles, ACES pay income, typically trade at a premium to conversion value and carry call protection. Unlike vanilla convertibles, they typically have shorter maturities and they mandatorily convert into stock at maturity. Typical ACES are: Structured as preferred stock; Usually issued at the same price as the underlying common stock; Convertible at a premium; Paying a fixed quarterly dividend (or coupon, if issued as a bond) which provides a significantly higher yield (typically, 500 to 600 basis points at issuance) than the common stock; Usually non-callable for either three years or the life of the security; Often listed on the NYSE or AMEX (helping liquidity); and Automatically converted into common stock at the end of their life (usually three to four years). The number of shares received upon conversion will depend on the common stock price at maturity relative to the common stock price when the ACES was issued. SM

ACES is a servicemark of Goldman Sachs & Co. DECS is a servicemark of Salomon Brothers Inc. SM PRIDES is a servicemark of Merrill Lynch & Co. SM SAILS is a servicemark of CS First Boston. SM

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As an example of the ACES structure at issue, consider the Dole Food $2.75 ACES issued in August 1996 (Figure 18). Figure 18: ACES Terms at Issuance Dole Food Co. $2.75 ACES Price/Par Value

$39.25

Stock Price at Issue

$39.25

Dividend on ACES

$2.75

Dividend on Common Stock

$0.40

Conversion Premium

20.1%

Conversion Price

$47.125

Minimum Conversion Ratio

0.8329

Maximum Conversion Ratio

1.0000

Mandatory Conversion Date

15 August 1999

Call Protection

15 August 1999

Note. This particular issue has a small twist - the issuer is not the company, but rather a trust with the trust holding the Dole shares which are issuable on conversion. Despite this feature, these ACES are structured and trade much like any other ACES. Source: Goldman Sachs convertible research

What Does the Investor Receive at Maturity? Assuming the ACES is held to maturity, three pay-off scenarios are possible at mandatory conversion:

1. The stock price exceeds the conversion price. The investor receives 0.8329 shares of Dole Foods, the minimum conversion ratio. The value of the shares received is calculated by multiplying the conversion ratio by the current stock price. For example, if the stock price is $60 at maturity, the investor receives an economic value of $49.97 ($60 * 0.8329).

2. The stock price is between the issue price ($39.25) and the conversion price ($47.125). The investor receives the number of shares of the common stock equal in value to the issue price, calculated as: # Shares Received = Stock Price at Issuance ÷ Stock Price at Maturity For example, if the stock price is $45 at maturity, the investor receives 0.8722 shares with a value of $39.25, or the issue price of the ACES.

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3. The stock price is below the issue price. The investor receives one share of common stock. Figure 19: Dole Food ACES Payoff Profile at Maturity


Determining the value of the shares received at maturity is only part of the equation. The investor’s total return must also take into account the incremental dividends received throughout the life of the security. The total return for the Dole Food ACES if held to maturity is shown in Figure 20. This analysis underlines the fact that on a total return basis, ACES are quite similar to common stock. While the Dole ACES can outperform the common stock when the stock price declines, they should participate in a significant part of the upside (96% for Dole ACES) when the common stock appreciates.

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Figure 20: Total Return Analysis for Dole Food ACES if Held to Maturity Annual Total Stock Return

Stock Price at Mandatory Conversion Date

Value of Shares Received at Maturity

Annual ACES Dividend

-35%

$ 9.58

$ 9.58

$ 2.75

-30

12.26

12.26

-25

15.36

-20

ACES Annual Total Return

ACES Participation in Stock Price Movement

-30.5%

87.1%

2.75

-25.1

83.8

15.36

2.75

-19.9

79.4

18.90

18.90

2.75

-14.6

73.1

-15

22.90

22.90

2.75

-9.4

62.9

-10

27.41

27.41

2.75

-4.3

42.7

-5

32.45

32.45

2.75

0.9

N/M

0

38.05

38.05

2.75

6.0

N/M

5

44.24

39.25

2.75

7.0

140.1

10

51.04

42.51

2.75

9.7

97.0

15

58.49

48.72

2.75

14.5

96.5

20

66.62

55.49

2.75

19.2

96.2

25

75.46

62.85

2.75

24.0

96.0

30

85.03

70.82

2.75

28.7

95.8

35

95.37

79.43

2.75

33.5

95.7

Note. Analysis assumes ACES are purchased on issue date and held to maturity. Analysis assumes ACES dividend of $2.75 and common dividend of $0.40 per annum for the life of the security. Source: Goldman Sachs convertible research

Callability One additional consideration is the possibility of the security being called by the issuer prior to maturity. Although most ACES are not callable for the life of the security, some of these structures are callable in the year prior to mandatory conversion. As with a plain vanilla convertible, the issuer will typically call the convertible only when the common stock price exceeds the conversion price. If the stock price has declined during the first three years, the company will have very little incentive to redeem the ACES prior to maturity. Alternatively, if the common stock has performed strongly, the probability of the issuer calling the ACES is high. If it is clear that the minimum conversion ratio will be in effect, the company has strong incentive to call the ACES. If the conversion ratio is still between the maximum and minimum, the issuer must weigh the saving in

34


incremental dividends (ie the dividend on shares is typically lower than on the ACES) versus the possibility that the stock will go higher and the company will be required to issue fewer shares. Breaking Down ACES A useful approach to valuation involves breaking the ACES structure into its parts. This allows the investor to view the ACES as a combination of four securities:

1. Long one share of common stock; 2. Short one at the money call option struck at the ACES issue price ($39.25 in the Dole Food example);

3. Long a fraction (0.8329 in the Dole Food example) of an out of the money call struck at the conversion price ($47.125); and

4. Long the present value of the ACES’ incremental income above the dividend paid on the stock. The combination of short one at the money call and long a fraction of one out of the money call leaves the investor with a net loss relative to simply owning the common stock. To compensate for this loss, the investor receives a greater dividend than is paid on the common stock. Thus, in our Dole Food example, the ACES will be fairly valued if the price is equivalent to the package in Figure 21. Figure 21: Valuing ACES Dole Foods ACES Price = Dole stock price + 0.8329 call struck at $47.125 - one call struck at $39.25 + Present Value of remaining dividend on ACES - Present Value of dividends on common stock Source: Goldman Sachs convertible research

The above equation invites further analysis. For an investor to be indifferent between the common stock and the ACES, the present value of the yield advantage must equal the cost of buying an at the money call and selling part of an out of the money call option:

35


PV(Yield Advantage)

=

At the money call – 0.8329 out of the money call

If the present value of the yield advantage is higher, the ACES is more attractive. If the value of the call spread is greater, then the common stock is more attractive to an investor, despite the higher yield on the ACES. Exchangeable ACES Exchangeable ACES are convertible into a stock other than that of the issuing company. The ACES structure can be very useful in helping a company to monetize its stake in another company with possible advantages including: 1. Guaranteed Sale. ACES guarantee the issuer that it will sell the stock, unlike an exchangeable bond which has the possibility of becoming ‘busted’ and remaining on the company’s balance sheet until maturity. 2. Possibility of Premium Pricing. In comparison with selling stock outright, ACES allow the issuer the possibility of retaining some of any stock price appreciation. 3. Tax Advantages. ACES allow the issuer to defer capital gain recognition until the ACES are exchanged while receiving the proceeds at the time of issue.

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Convertible Quarterly Income Preferred Shares (Convertible QUIPS) Introduction to Convertible QUIPS Convertible Quarterly Income Preferred SharesSM (convertible QUIPS) are a convertible security also known by the acronyms Convertible TOPrSSM and TECONSSM . From the investor’s viewpoint, convertible QUIPS are essentially convertible preferred securities, ie they are structured as preferred stock convertible into common shares at a premium and they pay quarterly dividends to the investor. A typical convertible QUIPS appears to an investor with the following characteristics: Structured as preferred stock with a $50 par value; Structured to have a maturity of 15-30 years with non-callability for three to five years; Convertible at a premium; and Expected to pay a fixed quarterly dividend which is not eligible for Dividend Received Deduction. The actual structure of a convertible QUIPS is rather more complicated than that of a traditional convertible preferred security although most investors will be indifferent between the two structures, allowing comparable pricing levels to exist. Convertible QUIPS Structure The issuing company establishes a wholly owned special purpose vehicle (SPV) whose sole purpose is to issue preferred stock. The SPV, which is essentially a pass-through entity, sells the convertible QUIPS to investors. The SPV then lends the proceeds of the convertible offering to the parent in return for a convertible subordinated debenture with identical terms to the convertible QUIPS.

SM

QUIPS is a servicemark of Goldman Sachs & Co. Convertible TOPrS is a servicemark of Merrill Lynch & Co., Inc. SM TECONS is a servicemark of JP Morgan & Co. SM

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Figure 22: Breaking Down a Convertible Quips


As an example of the convertible QUIPS structure at issue, consider Host Marriott $3.375 convertible QUIPS issued in November 1996 (Figure 23). Figure 23: Convertible QUIPS Terms at Issuance Host Marriott $3.375 Convertible QUIPS Issue Price/Par Value

$50


$15.125

Dividend on QUIPS

$3.375


0.0%

Conversion Premium

23%

Conversion Ratio

2.6876

Call Protection

Hard Call Protection to 2 December 1999

Maturity

2 December 2026


The Issuer’s Perspective By issuing a convertible QUIPS rather than a traditional convertible preferred, the issuer achieves significant benefits, including: Increased equity credit from rating agencies. The issuer can receive partial equity credit because the bonds do not appear on the issuer’s balance sheet as debt, but as a ‘minority interest’ in the SPV. Deduction of payments for tax purposes. It is currently the case that, given that the issuer has essentially ‘sold’ convertible subordinated debentures to the SPV, it is entitled to deduct the coupon payments for tax purposes.

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Valuation and Performance A convertible QUIPS can generally be valued as traditional convertible preferred stock although the structural differences outlined above may affect the valuation techniques for certain types of investor. Specifically, from the viewpoint of some US taxable corporate investors, the loss of the Dividend Received Deduction will make the convertible QUIPS less attractive than a similarly priced traditional convertible preferred. These investors should compare convertible QUIPS to traditional convertible debt for valuation purposes. In the secondary market, convertible QUIPS perform similarly to traditional convertible preferred securities. They somewhat outperform common stock on the downside given their enhanced yield and implied investment value; equally, they slightly underperform the common stock on the upside given their convertibility into the underlying common stock at a premium. Convertible MIPS Originally, convertible QUIPS were called convertible Monthly Income Preferred SharesSM (convertible MIPS). Given that these securities were issued out of Limited Partnerships and Limited Liability Companies, they were required to pay income on a monthly basis (for US tax reasons). More recently, the structure has evolved into issuance from a Delaware Business Trust allowing for quarterly payments.

SM

MIPS is a servicemark of Goldman Sachs & Co.

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Credit Enhanced Debt Indexed To Stock (CrEDITS) Introduction to CrEDITS Credit Enhanced Debt Indexed To Stock (CrEDITS) is a recent market innovation which allows companies to enhance the credit quality of new convertible securities. CrEDITS are identical in all respects to other convertibles except that the principal and coupon payments are guaranteed by an irrevocable Letter of Credit from a highly rated financial institution. Since the instrument is guaranteed it receives the higher credit rating of the financial institution. Effectively, that institution charges a fee to guarantee the instrument and there is a corresponding reduction in yield to maturity to the investor. This is particularly effective if the financial institution attributes a substantially better credit quality to the issuing company than do investors in the convertible market (ie the guarantee will cost less than the yield foregone by convertible investors). While the issuer must pay a Letter of Credit fee for the guarantee it is able to take advantage of the market’s favorable view towards strong investment grade credits. CrEDITS Structure Taking a hypothetical example, if BB-rated Company X wishes to issue a five year (non-call three years) convertible security with a 15% initial conversion premium, investors are willing to buy it with a 6% coupon (and therefore yield to maturity) at issue (Figure 24). Figure 24: Simplified Annual Cost to Issuer of Normal Convertible

Annual coupon cost = 6% per annum Source: Goldman Sachs convertible research The same investors are willing to buy a similar structure but with principal and income guaranteed by AA-rated Financial Institution Y and with just a 4% coupon. If Financial Institution Y is willing to lend its credit to guaranteeing the security for less than the 2% annual yield differential implied by the two pricings then it will make economic sense for the issuer to incorporate the guarantee in the structure. Beyond this hypothetical situation, the CrEDITS structure can allow an issuer to consider a far broader variety of possible structures (eg 0% coupon, higher premium, and aggressive call provisions) which may not have been salable without the credit-enhancement feature. Figure 25 is a much simplified depiction of the mechanics underlying CrEDITS.

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Figure 25: Simplified Annual Cost to Issuer of CrEDITS

Annual coupon cost plus cost of guarantee = 5.25% per annum Source: Goldman Sachs convertible research Attraction to Investors The use of the CrEDITS structure greatly increases the number of potential investors in a convertible offering given the broader investor base for investment grade instruments. Recent successful CrEDITS transactions have come from IPCL (Indian Petrochemicals Corporation) in India and GVC in Taiwan. At an intuitive level, it is very attractive for a convertible investor to be able to combine in one security: (1) the upside potential of an emerging market or growth stock; (2) a name with high stock volatility; and (3) high quality downside protection uncorrelated to the shares.

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Exchangeable Structures Introducing Exchangeables Exchangeable structures are similar to convertibles in that they are typically characterized by the attachment of an equity option to a fixed income instrument. The difference is that whereas the guarantor of a convertible is the same company as that of the shares to be issued, the guarantor of an exchangeable is a different company to that of the underlying shares (although typically the guarantor holds those underlying shares). This type of structure is often used by a company divesting a holding in another company. Structure of an Exchangeable Taking an actual example, in December 1996 the German bank Bankgesellschaft Berlin issued a bond guaranteed by its own credit but exchangeable into shares of the German retailer Metro. The security was similarly structured at issue to a conventional convertible although there were certain key differences. As Figure 26 illustrates, the security combines elements of the issuer’s credit with certain properties of the underlying shares. Figure 26: (Bankgesellschaft Berlin) Metro Exchangeable Terms and Valuation at Issue (Bankgesellschaft Berlin) Metro Exchangeable Security Issuer

Bankgesellschaft Berlin

Coupon

3.25%

Maturity

3 December 2001

Exchange Property

Metro Shares

Metro Share Price Volatility

24%

Dividend on Metro (E)

1%

Bankgesellschaft Berlin Credit

Aa1

Call Protection

Hard Call Protection to December 1999. 140% Provisional thereafter


From an investor perspective, there are three important valuation factors when considering exchangeables: 1. Stock price volatility. In valuing an exchangeable security, an investor should consider the volatility of the underlying shares, not that of the issuer shares. 2. Credit Correlation. When valuing a convertible, investors should factor in the probability of a significant correlation between the share price and the

42


credit of the issuer (especially for weaker credits). In the case of an exchangeable, this correlation is typically far less marked (or non-existent) with a positive implication for valuation. 3. Efficient Callability. Given that many European exchangeables have been issued by large financial institutions we would expect an unusually high degree of efficiency in calling them. Mandatory Exchangeables The inherent problem for an issuer in the sale of equity through an exchangeable arises in the event that the stock price has traded down at maturity and it has not actually sold the underlying shares. Instead it faces a substantial cash call of the redemption value. Clearly a mandatory security eliminates this risk given that conversion will be compulsory at some point in its life. As a result, exchangeables modeled on the ACES structure have been widely issued in the US. Notation Exchangeable securities are generally listed with the issuer first in brackets and then the company of the underlying shares second. For example (Deutsche) Allianz 1% 2001 was issued by Deutsche Bank exchangeable into the shares of Allianz. Privatization Exchange Notes (PENs) Exchangeable securities are an increasingly important financing tool for use in government privatization programs. Essentially, Privatization Exchange Notes (PENs) are similar to the instruments profiled above except that the issuing entity is a sovereign government and the exchange property are the government held shares in a partly privatized corporation. Both the Italian and Pakistani governments have issued such structures and we profile below the issue terms of the (Italian Government) INA PENs.

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Figure 27: Summary Issue Terms for the (Italian Government) INA PENs Lira Tranche

US$ Tranche

Issuer

Italian Government

Italian Government

Underlying Shares

INA

INA

Issue Size

LIT 1,610bn

US$ 1.06bn

Coupon

6.5%

5%

Maturity

28 June 2001

28 June 2001

Hard Call Protection

Hard to 1 July 2000

Hard to 1 July 2000

Rating (Moody’s)

Aa3

Aa3


44


Original Issue Discount (OID) Convertible Securities Introduction to OID Securities The section below reviews original issue discount (OID) convertible securities. Within this description are included both zero coupon and deep discount (low) coupon convertibles. The zero coupon convertible structure was developed in early 1985 in the US, and often goes by the acronym LYONs, or Liquid Yield Option Notes®. Discount coupon convertibles are similar to zero coupon ones but (as the name suggests) pay a small coupon. Description Original issue discount convertible bonds are distinguished from vanilla convertible bonds in several ways. We have reviewed the structure (below) using the Marriott International, Inc. zero coupon convertible bond issued in October 1996 as an example (Figure 28). Figure 28: Issue Terms for Marriott International, Inc. 0% 2011 Coupon

0.00%

Yield to Maturity at Issue

4.25%

Issue Price Per Bond

$532.15

Par Value

$1,000

Initial Premium

20.0%

Initial Conversion Price

$60.75

Conversion Ratio

8.760

Call Protection Expires

25 March 1999

Initial Call Price

$603.71

Issue Size (face amount in millions)

$540.3

Issue Date

25 March 1996

Maturity Date

25 March 2011

First Put Date

25 March 1999

First Put Price

$603.71

Second Put Date

25 March 2006

Second Put Price

$810.36


No or low coupon paid on the convertible. In the case of a zero, the convertible pays no coupon, but instead the ‘interest payments’ are effectively ®

LYONs is a registered servicemark of Merrill Lynch & Co.

45


deferred until final redemption. The bonds are issued at a deep discount to par value (typically issue price is between 20% and 40% of par) and have a yield to maturity reflecting the accretion from the issue price to par. For a discount convertible, the security pays a low coupon and again the remaining value of the ‘interest payments’ is deferred, giving the bonds a higher yield to maturity than current yield. The Marriott International convertible bond pays no coupon, but had a yield to maturity at issue of 4.75%. The initial issue price was $532.15 per bond (with a par value of $1,000). The difference between the par value and the initial issue price ($467.85) can be viewed as the value of the deferred interest payments over the life of the bond. Put options. Almost all OID convertibles carry the option for the investor to put them after the first three to five years and then every five years thereafter. On these dates, the investor has the option to sell the convertible back to the issuer at a pre-determined price. This price is usually equal to the initial price of the bond plus an amount equal to accretion at the yield to maturity which applied at issue. In the case of the Marriott International convertible, the investor has two put options. On 25 March 1999 (three years after issuance), the bonds can be put back to the company at $603.71, and on 25 March 2006 the bonds can be put back to the issuer at a price of $810.36. Call protection. OID structures typically carry three to five years of call protection. As with other convertibles, the issuer will generally give 15 to 30 days of call notice before they can redeem the securities. The Marriott convertible bonds carry call protection until 25 March 1999. At that time, the bonds may be called by the company at their accreted value. For example, on 25 March 1999 the call price is $603.71, representing the issue price of $532.15 plus the accreted value of $71.56 (equivalent to 4.25% accrued over three years on the initial price of $532.15). Conversion premium. OID convertibles are typically issued with a relatively low conversion premium of approximately 10%-20%. However, given that these securities are convertible into a fixed number of shares, the ‘implied premium’ actually increases as the value of the convertible accretes to par. For example, the initial conversion premium on the Marriott convertible bonds was 20%, with a fixed conversion ratio of 8.76. This represented an initial conversion price of $60.75 (issue price divided by conversion ratio). The conversion price adjusts upward over the life of the convertible as the implied call/put/redemption prices accrete upwards. The conversion price at maturity will be $114.15 (calculated as the final value of $1000 divided by the fixed conversion ratio of 8.76).

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Valuation In the wide spectrum of convertible structures, OID convertible bonds are the closest to a fixed income security. Although most OID convertibles are issued with a maturity of 15 to 25 years, investors typically view the bonds as a short maturity instrument due to the put options. At the put dates the investor has the option to receive the initial price plus the accrued value of the unpaid coupon from the issuer regardless of how the common stock has performed over that time period. In simple terms, an OID convertible can be valued as a 3- to 5-year straight bond (depending on when the first put occurs) plus a 3- to 5-year call option. In the case of Marriott International, the bonds could be valued at the issue date as a combination of a three year zero coupon bond plus a 3 year call option on Marriott stock. Considerations for Issuers and Investors One motivation for companies to issue zero coupon convertible bonds is the tax treatment. Although no cash interest is actually paid by the issuer, it can deduct the accrued interest on the convertible. This makes a zero coupon convertible advantageous from a tax and cash flow perspective. Proposed legislation in the US may eliminate this tax advantage, making the zero coupon structure less attractive for potential issuers given that they will no longer be allowed to deduct the accrued interest. On the other hand, investors must pay taxes on the convertible’s accrued interest even though they have not received an actual cash coupon. This ‘phantom’ interest is taxed as ordinary income. This makes the zero-coupon unattractive to several different types of investor groups. In addition, the investor must forego the accreted value of the convertible if the security is converted.

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Reset Features Introduction to Reset Features Reset features allow for an alteration to the conversion ratio of a convertible security under certain circumstances. Typically the reset will offer some compensation in the event of share price depreciation over the life of the security (or a part thereof). Reset features are becoming an increasingly popular feature in the convertible market. Downward Resets Downward reset clauses allow for an increase in the number of shares investors receive on conversion in the event that the share price is below the conversion price on a certain pre-specified date (or dates). Typically, this will result in a reset of the conversion price to the level of the share price but only up to a point. The downward reset floor sets a limit to the amount by which the exchange price may be altered and is typically expressed as a percentage of the conversion price. Figure 29: Pay Off Profile at Maturity for a Mandatory Convertible with Reset Feature


Figure 29 profiles the expected pay-off of a mandatory resettable convertible at maturity. The unbroken line (ABCE) corresponds to parity and the horizontal kink in the line (BC) reflects the alteration of the conversion ratio by reset. Depending on the share price at the reset date, the conversion ratio may be reset to any point along the line BC; parity following reset can therefore be on any of the possible lines between the angles of lines ABD and ACE. Upward Resets Upward reset clauses allow for a decrease in the number of shares investors receive on conversion in the event that the share price is above the conversion price on a certain pre-specified day or days. Typically, this will result in a reset of the exchange price to the level of the share price. Upward resets typically do not

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exceed the initial conversion price ie holders of the convertible do no worse than under the original circumstances of issue. Negative Gamma The inclusion of reset features in convertibles can lead to unusual price action at certain share price levels. For example the first month of 1997 was characterized by widespread discussion of negative gamma in Japanese bank convertibles. The phrase negative gamma refers to the situation where a convertible’s sensitivity to the price of the underlying shares is rising at the same time as the actual value of the underlying shares is falling. Figure 30: Negative Gamma Illustrated


Referring to Figure 30 (above), the key point to note is what is happening around point B as the share price falls. As the reset floor is approached, the rate of fall of the convertible price (delta) increases for a given share price fall. This characteristic can create increasing pressure on the share price as arbitrageurs sell more stock to cover their increasing exposure to share price downside accelerating the share price decline in the process. This creates a situation which is the reverse of conventional convertible delta hedging techniques where arbitrageurs are long volatility (and expect to sell stock as the stock price rises and buy stock as the stock price falls). Instead arbitrageurs will be short volatility and will buy stock as the stock price rises and sell stock as the stock price falls. Note: there are clearly limitations to the usefulness of the charts in understanding the trading patterns of these instruments given that they only represent pay-off at maturity versus the dynamic trading patterns of instruments over time.

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Credit Correlations The concept of negative gamma is not unknown to the convertible market given that there will often be a strong correlation between share price and credit in weaker credit quality convertibles. A good example are the US airline industry convertibles in 1994-95 where premiums for several instruments tended to contract on share price weakness and to expand on share price strength. What is less familiar is the development of negative gamma in high quality instruments ie the disappearance of downside protection on stock price weakness is implicit in the structure rather than being conditional on perceptions of weakening credit.

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Yield Enhanced Stock (YES also known as PERCS) Introduction to Yield Enhanced Stock (YES) Yield Enhanced StockSM (YES) is a convertible security also known by the acronyms PERCSSM and CHIPSSM. YES mandatorily converts into common stock at maturity and offers investors a higher current dividend than the underlying common stock. Investors’ participation in stock price appreciation is capped. YES offers a significantly different return profile from that of a vanilla convertible security. In the event of share price weakness, YES should slightly outperform the common stock given its enhanced yield. In the event of share price strength, YES should underperform the common stock given that upside participation is capped at a pre-specified level. Description of the Structure The typical YES is: Structured as preferred stock; Usually issued at the same price as the underlying common stock; Capped at a premium of 30%-45% above the stock price at issue; Paying a fixed quarterly dividend which provides a significantly higher yield than the common stock at issuance; Often listed on the NYSE or AMEX (improving liquidity); Usually callable at any time prior to the mandatory conversion date; and Automatically convertible into common stock at the end of its life (usually three to four years). The number of shares received upon conversion will depend on the common stock price at maturity relative to the common stock price when the YES was issued. As an example of the YES structure at issue, consider the SunAmerica $3.188 PERCS issued in October 1996 (Figure 31).

SM

YES is a servicemark of Goldman Sachs & Co. PERCS is a servicemark of Morgan Stanley & Co. SM CHIPS is a servicemark of The Bear Stearns Companies Inc. SM

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Figure 31: YES Terms at Issuance SunAmerica $3.188 PERCS Issue Price/Par Value

$37.50


$37.50

Dividend on PERCS

$3.188


$0.300

Cap Premium

35.0%

Cap Price

$50.625

Mandatory Conversion Date

31 October 1999

Call Protection

6 November 1996


What Does the Investor Receive at Maturity? It is quite simple to calculate what the investor receives if the YES is held to maturity. At the time of mandatory conversion, only two scenarios are possible: 1. The stock price exceeds the cap price. The investor receives the number of shares of common stock equal in value to the cap price, calculated as: # Shares Received = Cap Price ÷ Stock Price at Maturity In the case of the SunAmerica PERCS, if the stock price is $60 at maturity, the investor receives 0.8438 shares with a value of $50.625 or the cap price of the YES. 2. The stock price is below the cap price. The investor receives one share of common stock. It should also be noted that a reduced conversion ratio (versus 1) is only activated if the issuer formally calls the security before maturity. Typically a call period of 30-60 days will be specified and the call price will be calculated on a ‘look-back’ basis ie the price is calculated as the average of the share price between six and two days prior to the announcement of the call.

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Figure 32: SunAmerica PERCS Payoff Profile at Maturity


Determining the value of the shares received at maturity is only part of the equation. The investor’s total return must take into account the incremental dividends received throughout the life of the security. Assuming it is held to maturity, the total return for the SunAmerica PERCS is shown in Figure 34. This analysis shows how the high dividend and the conversion cap impact the YES’ total return. While the SunAmerica PERCS modestly outperforms the common stock when the stock price declines, it participates in more than 100% of the upside for modest stock price appreciation. In the case of a significant stock price movement on the upside, the PERCS should underperform the common stock due to the cap. Breaking Down YES A useful approach to valuation is to break the YES structure into its parts. Using this approach, the YES is essentially identical to a buy-write options strategy and can be viewed as a combination of three securities: 1. Long one share common stock; 2. Short one out of the money call option struck at the YES cap price ($50.625 in the SunAmerica example); 3. Long the present value of the YES’ incremental income above the dividend paid on the stock. The higher yield on the YES relative to the common stock is essentially the money gained by selling the out of the money call option. However, unlike a traditional buy-write strategy, the premium is not received in an initial lump sum

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but is instead paid out in quarterly dividends. Thus, in our SunAmerica example, the YES will be fairly valued if the price is equivalent to the package in Figure 33. Figure 33: Valuing YES SunAmerica PERCS Price = SunAmerica stock price - one call struck at $50.625 + Present Value of remaining dividends on PERCS - Present Value of remaining dividends on common stock Source: Goldman Sachs convertible research

The above equation invites further analysis. For an investor to be indifferent between the common stock and the YES, the present value of the yield advantage must equal the value of the call: PV(Yield Advantage) = One call struck at $50.625 If the present value of the yield advantage is higher, the YES is more attractive. If the call value is greater, then the common stock is more attractive to an investor, despite the higher yield on the YES.

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Figure 34: Total Return Analysis for SunAmerica PERCS if Held to Maturity Value of Shares Received at Maturity

Annual Total Return on stock

Stock Price at Mandatory Conversion Date

-35%

$ 9.40

$ 9.40

$ 3.188

-30

11.96

11.96

-25

14.92

-20

Annual YES Dividend

YES Annual Total Return

YES Participation in Stock Price Movement

-27.9%

79.8%

3.188

-22.6

75.4

14.92

3.188

-17.4

69.4

18.30

18.30

3.188

-12.1

60.6

-15

22.13

22.13

3.188

-6.9

46.3

-10

26.44

26.44

3.188

-1.8

17.7

-5

31.25

31.25

3.188

3.4

N/M

0

36.60

36.60

3.188

8.5

N/M

5

42.51

42.51

3.188

13.6

272.4

10

49.01

49.01

3.188

18.7

187.3

15

56.13

50.63

3.188

19.9

132.8

20

63.90

50.63

3.188

19.9

99.6

25

72.34

50.63

3.188

19.9

79.7

30

81.49

50.63

3.188

19.9

66.4

35

91.36

50.63

3.188

19.9

56.9

Note. Analysis assumes PERCS are purchased on issue date and held to maturity. Analysis assumes PERCS dividend of $3.188 and common dividend of $0.30 per annum for the life of the security. Source: Goldman Sachs convertible research

Callability The issuer can typically call YES at any time prior to the mandatory conversion date at a pre-specified call price. Despite this call feature, the holder of a YES security is ‘protected’ from losing future dividends. Specifically, the call schedule will ensure that the YES holder is paid for the dividend advantage of the YES over the common stock between the call date and maturity. The YES call price declines daily at a fixed rate until a few months before the mandatory conversion date. The call schedule assumes a flat stock dividend and is not adjusted if the stock’s dividend decreases or increases. As a result of these unique call features, the issuer has little motivation to call the YES early. Only under a scenario where the stock price increases significantly

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above the cap and the company anticipates a decline in its stock price in the future would it make sense for a company to call the security.

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4.

Approaches to Convertible Investment Investing in Convertibles Summary Valuation Influences The Rationale for Investing in Convertibles Convertible Strategies for Equity-Oriented Investors Convertible Strategies for Fixed Income and Risk-Averse Investors Convertible Funds Hedge Funds Investment Scenarios Market Timing Market Retrenchments Trading Range Strategies Sectoral Considerations High Risk Situations Emerging Markets Misvaluation Equity ‘Kickers’ Improving Credit Quality Economic Recovery Convertible Specific Investment Risks Buyer Beware Anti-Dilution Provisions Takeover Provisions Screw Clauses Stripping Convertible Bonds Origins of Convertible Stripping Stripping a Convertible Secondary Market Implication

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Investing in Convertibles Summary Valuation Influences Summarizing our previous discussions, we can conclude that a convertible’s value will be positively correlated with: Stock prices. The higher the stock price, the greater is parity and the intrinsic value of the convertible to an equity investor. Volatility. The greater the volatility of the underlying stock, the greater the value of the convertible’s embedded warrant. Credit quality. The greater the credit quality of the issuer, the lower the required credit spread on its straight debt and the higher the fixed income value of the convertible. Call protection. In issues without call protection investors are effectively short a call to the issuer. The longer the call protection, therefore, the lesser the value of the option that investors are short. Conversely, a convertible’s value will be negatively correlated with: Interest rates. Higher interest rates on risk-free securities reduce the fixed income value of the convertible and hence negatively impact valuation. Note that even though higher interest rates are typically a positive for warrant valuations, the negative impact on fixed income valuations usually dominates. This is because for most newly issued convertibles the fixed income value is at least 70%-80% of the issue price, while the warrant component is only 20%30%. Stock yield. Higher (and/or rising) stock yields are a negative factor for warrant valuation and also in terms of the intrinsic yield-enhancement rationale for holding a convertible.

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Figure 35: Convertible Valuation Influences Valuation Influence Rises/Increases

Convertible Price

Call Protection

↑

Credit Quality

↑

Interest Rates*

↓

Stock Yield

↓

Stock Prices

↑

Stock Price Volatility

↑

* Assumes that the value of a convertible’s fixed income component outweighs its equity option component. Source: Goldman Sachs convertible research

The Rationale for Investing in Convertibles As we review below, there are a number of compelling reasons for incorporating convertibles into investment strategies. It is a commonly expressed fallacy, however, that convertibles are a good investment vehicle because they give investors the best of both worlds, outperforming bonds when share prices rise and outperforming stock when share prices fall. The investor would have done better still investing directly in shares when share prices rise (since there can be assumed to be some contraction of the convertible’s premium) and would have been better off owning straight debt when share prices fall (since the convertible will still fall to some degree whereas the value of straight debt will be relatively uncorrelated to the stock price). The trouble with the methodology used in the previous paragraph is that it relies on the benefit of hindsight. Rather than use ex-post analysis it is better to use exante analysis which explicitly recognizes that investment decisions carry risks - at the time of the investment the investor could not know whether share prices would subsequently rise or fall. Thus, a better way to express the possible advantages of convertibles is to say that: Unlike bonds, they offer a degree of upside participation when share prices rise; Unlike stock, they offer a degree of downside protection when share prices fall; and They typically provide some degree of yield advantage over common stock. Thus, we can conclude that a convertible will have a volatility and expected return less than those of the issuer’s common stock but greater than those of its straight debt.

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Over shorter periods of time the relationship between the various asset classes breaks down, with different assets outperforming at different times. Indeed, over the 1973-95 period convertibles as an asset class actually came close to replicating the performance of the S&P 500. This subject is discussed in more detail when we examine the historic performance of convertibles in Chapter 5. Convertible Strategies for Equity-Oriented Investors Equity investors use convertibles either to enhance the income component of their total returns or to better manage risk in their equity portfolios. They tend to be most sensitive to the levels of premium over parity, the length of call protection and the yield advantage over the common stock. They tend to favor balanced and in the money convertibles. An attractive convertible is usually one that offers a favorable asymmetry in its returns. For example, a convertible that gives a 70% participation in any upward move in the stock, but only gives a 40% participation in any downside might normally be considered attractive. The lower the premium and the longer the call protection, the greater the upside participation, while the higher the yield relative to an issuer’s straight debt, the greater the degree of downside protection. One of the key insights of convertible analysis is that the more volatile a stock, the greater the asymmetry between upside participation and downside protection. Figure 36 shows a simplified example of a noncallable convertible with one year to maturity (at a price of par) that is trading at 110, a 10% premium to parity. In Case A the stock can either rise or fall 20% over the year, whereas in Case B it can move 40% in either direction. At maturity, the convertible will be worth the higher of parity or its par redemption value. If the share price rises, the premium shrinks to zero - the convertible holder will participate in more of the share upside if this 10% premium can be amortized over a 40% stock rise rather than a 20% stock rise. On the downside, the redemption floor is the same irrespective of how much the stock falls. Case B, which gives investors 75% of the stock upside but only 25% of the downside, is more attractive than Case A, which only gives 50% both ways.

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Figure 36: Illustration of Convertible Asymmetry Case A

Case B

Time to Maturity

1 year

1 year

Convertible Price

110

110

Parity

100

100

Expected 1 Year Stock Movement

±20%

±40%

Convertible Price at Maturity if Stock Rises by Maximum Expected

120

140

Convertible Price at Maturity if Stock Falls by Maximum Expected

100

100

Upside Participation

10 points or 50% of move in parity


Downside Participation




Occasionally, fund managers shy away from convertibles saying that ‘if I like a company I’ll buy its stock and if I think that the shares are going down I won’t buy them’. The fallacy of this argument is that the investor fails to recognize that any investment decision is subject to uncertainty and the investor is claiming a (sometimes unwarranted) degree of infallibility. After all, if investors really are convinced that a stock is going up, then they should not buy stock either, but should rather buy more leveraged instruments such as warrants or call options. Convertible Strategies for Fixed income and Risk-Averse Investors Fixed income investors and other risk averse investors use convertibles as a means of enhancing overall portfolio returns without excessively increasing their risk. Typically, they use out of the money and balanced convertibles (which tend to be less sensitive to premiums over parity). There are two related investment strategies that may be pursued by fixed income investors in the convertible market: (1) buying misvalued out of the money convertibles as a direct alternative to debt; and (2) buying balanced convertibles with the objective of introducing some conservative equity exposure to a portfolio. 1. Convertibles as an alternative to debt. Out of the money convertibles periodically become mispriced relative to the straight corporate bond market and offer valuation driven opportunities to fund managers.

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2. Using convertibles to introduce equity exposure to portfolios. Fixed income investors will periodically use convertibles as a means to achieve limited levels of equity exposure within essentially fixed income portfolios. Convertible Funds Dedicated convertible funds are a growing investor group which tend to look at all of the factors which affect convertible valuation. Hedge Funds Hedge funds seek to exploit the asymmetry between returns on stocks and other assets in order to create a riskless return. The most common form of hedge would involve a long position in a convertible and a short position in the underlying stock.

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Investment Scenarios The following cases illustrate scenarios where investors may wish to consider investing in convertibles. Market Timing Very often, investors will want to gain exposure to a stock but find it difficult to buy ‘at the bottom’. Buying a balanced or in the money convertible as an alternative gives investors immediate exposure to the stock. If it subsequently turns out that the stock has indeed bottomed out, then investors can switch out of the convertible into the stock, having already participated in some of the upside from the trough. Conversely, if the share price falls further, then the convertible offers the investor some downside protection. Figure 37 profiles the Nedlloyd Group 4.5% 2001 convertible. Investors who bought this instrument at issue were protected from some of the share price depreciation (A) and eventually participated in some of the renewed share price strength (B). Clearly, the eventual convertible price appreciation (C) was reflective not only of share price appreciation but also of: (1) more generally improved market sentiment on the stock (ie Nedlloyd credit had some leverage to the share price) and (2) a generally positive credit spread and bond market environment. Figure 37: Nedlloyd Group 4.5% 2001

Market Retrenchments Although equities tend to outperform bonds over long periods, equity growth is not smooth over time. Investors who want long run exposure to a company, but who think that in the short term either the stock or the market is due for a

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retrenchment, can switch into a convertible. If the shares subsequently go down, the conversion premium should expand, implying relative outperformance. Once the investor believes the correction is over he can switch back into the stock. Figure 38 shows the premium on the Quintiles Transnational 4.25% 2000 convertible bond over the time since its issue. Significantly, convertible bond holders have moved within a narrower band of upside/downside moves than has the value of parity since January 1997. That is to say, the premium has expanded on share price weakness (AB) to give relative outperformance versus the underlying shares. Figure 38: Quintiles Transnational 4.25% 2000 Premium (%)


Trading Range Strategies If an investor is bullish on a stock in the long term but believes that in the short term it will trade within a narrow range, they can swap into a higher yielding balanced or in the money convertible and enhance their total return while maintaining exposure to any upward movement in the stock. In effect, investors are being ‘paid to wait’ for an eventual upturn. The Royal Sun Alliance 7.25% 2008 convertible (Figure 39) is an example where investors achieved yieldenhanced exposure to a range-bound stock (AB) before participating in the eventual stock price break out (CD).

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Figure 39: Royal Sun Alliance 7.25% 2008

Sectoral Considerations Sometimes investors may feel that fundamental considerations should lead them to alter the balance of their portfolio. In cases where these shifts in fundamentals are difficult to assess, it may make more sense to own a risk-adjusted instrument such as a convertible rather than stock. For example, if there are tentative signs of economic recovery, then investors should consider investing in convertibles on cyclical stocks. Likewise, convertibles may allow investors to achieve exposure to the commodity sector while managing their risk exposure. In the gold sector, for example, Ashanti 5.5% 2003 (Figure 40) vastly outperformed its underlying ADRs as their price fell.

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Figure 40: Ashanti 5.5% 2003

High Risk Situations In cases where there is explicitly a high degree of risk in the businesses of the underlying issuer (for example, a recovery situation or a company developing an untried technology) the attractions of a more defensively-oriented instrument are clear. Figure 41 profiles the price and parity of the VLSI 8.25% 2005 convertible bond from issue in September 1995. The premium expansion on stock price weakness (AB) highlights the usefulness of the convertible in managing portfolio risk. Figure 41: VLSI 8.25% 2005


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Emerging Markets Given the implicitly high levels of risk and prospective returns in the emerging markets, convertibles offer an attractive route to manage market exposure. For example, the price of the Bangkok Bank 1.5% 2006 convertible bond hardly fell (AB) during the period of stock price weakness (CD) following issue (Figure 42). Figure 42: Bangkok Bank 1.5% 2006

Misvaluation Sometimes a convertible may simply be mispriced relative to the equity (for example, if breakeven is inside call protection) and thereby provide an obvious buying opportunity. Additionally, conversion difficulty or lack of stock borrow can leave convertibles trading at a discount to parity, creating opportunities for long term investors to convert into the underlying shares at a profit. Equity ‘Kickers’ For more risk averse investors, the most common investment approach is to buy convertibles where the fixed income value represents 85%-95% of the value of the instrument, so the degree of downside protection is high but there is some upside exposure if the stock rallies. Since equities have historically outperformed bonds over the long run, this strategy tends to increase overall returns. It may also, of course, introduce a higher degree of systemic risk to portfolios. At issue (A), the A1/AA- (Moody’s/S&P) rated Aegon 4.75% 2004 convertible bond (Figure 43) fitted the profile of a relatively low risk premium instrument yet within two years was trading at 250% of its issue price (B) - high return for low initial risk. As the value of the convertible rose, the equity exposure (and thus risk) of the instrument had, of course, risen correspondingly.

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Figure 43: Aegon 4.75% 2004

Improving Credit Quality During the early phases of an economic recovery, the credit quality of many issuers, particularly the weaker credits often found in the convertible market, is perceived to improve and convertibles can offer exposure to these tightening spreads. Likewise in the emerging markets, out of the money convertibles may allow exposure to credit improvement situations. Banamex 7% 1999 (Figure 44) appreciated 76% from March (A) to September (B) 1995 despite having minimal equity sensitivity.

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Figure 44: Banamex 7% 1999

Economic Recovery Interest rates typically reach their lows early in an economic recovery and thereafter, as interest rates rise to counter rising inflationary pressures, bonds tend to underperform equities. In theory, fixed income funds can increase their returns during the latter part of an economic cycle by increasing their weightings in convertibles.

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Convertible Specific Investment Risks Buyer Beware Any investor in doubt over the exact structure of a convertible should review in detail the prospectus (or ultimately the trust deed) for that instrument. We briefly highlight below three issues which have historically been a problem for convertible investors. Anti-Dilution Provisions Most convertibles protect investors in the event that actions are taken which might dilute the convertible holders’ equity interest in the company. In Asia (ex-Japan), there have, however, been a number of instances in which convertible holders have been disadvantaged. In particular, convertible holders have proved vulnerable to the issuance of company-issued warrants on the shares into which their investments convert. In such situations, the new option will often be struck at (or close to) the money thus avoiding the need for a conversion ratio adjustment (ie many prospectuses fail to take account of the time value of money in such situations). Takeover Provisions Convertible investors should also be sensitized to the provisions of individual prospectuses in the event that the issuing company is taken over. At least three different possible scenarios exist on takeover:

1. Conversion to underlying shares. The security may become convertible into its underlying shares on completion of the takeover. While the acquisition will typically imply a ‘takeover premium’ in the share price (and hence parity), the investor is clearly losing the long-term value of the put option and the incremental yield advantage. In the time between announcement of the takeover and completion, the level of the premium should reflect the probability the market assigns to successful completion of the takeover.

2. Redemption at a specified price. The convertible may become redeemable at a specified price on completion of the takeover. This price will typically be par, a slight premium to par or an accreted value to reflect the age of a discount security.

3. New guarantor and conversion property. The convertible may remain outstanding with the newly merged company as guarantor and convertible into the shares of the new company. In the event that the offer was partly in cash, the security may be convertible into a combination of cash and shares. Valuation of the convertible will partly be driven by an assessment of the credit of the newly merged company.

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Often convertible holders will be offered a choice between more than one of the scenarios listed above. Additionally, some convertible prospectuses now carry takeover protection specifying an increase in the conversion ratio in the event of takeover. The extent of the change is typically correlated to the length of the remaining call protection. Screw Clauses Although not the most tasteful term in the financial markets, the expression ‘screw clause’ accurately describes the provision common to most prospectuses which specifies that, upon conversion, no adjustment will be made for interest or dividends. In simple terms, this means that upon conversion investors often do not receive any income accrued since the previous coupon payment.

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Stripping Convertible Bonds Origins of Convertible Stripping Straight fixed income investors have always been active participants in the convertible market at times when convertibles are trading close to their fixed income floor and with the equity component virtually worthless. More recently (1995-96), however, another type of market participant has grown in importance, focusing on the ‘stripping’ of the fixed income component from convertibles to leave a residual equity option. There were three catalysts for this development: 1. The increasing sophistication of the broader investor base; 2. The dramatic growth in the size of the convertible market during the early 1990s; and 3. The dramatic sell-off in a number of the Asian credit markets in 1994. The Asian convertible market was even more acutely impacted by this latter development than were the (small) corporate bond markets in the region. This was largely a result of the relatively unsophisticated nature of many convertible market participants. They typically originated from outside Asia and had a limited knowledge of the credits underlying the bonds they owned, plus a low tolerance for serious risk-of-loss. A dislocation between the convertible market and the local credit market thus developed creating opportunities for creditoriented investors who understood the underlying credits and were willing to buy in a volatile market. These investors initially focused on the limited number of securities trading at their fixed income floor but focus eventually shifted to encompass those issued by a favored credit but trading above their fixed income floor and with some equity value. This raised the question of how to ‘strip’ the bond from the equity portion, leaving an option which could subsequently be hedged. Ideally, were the convertible bond to be more valuable in the future than the ‘stripped’ elements, it would be possible to re-combine the two and create the regular convertible bond once more. Stripping a Convertible We review below a very simplified version of the methodology which has evolved for stripping convertible bonds. For the purpose of simplicity we have discussed the subject in the context of three hypothetical counterparties. Having identified interest in a strip transaction Counterparty 1 first buys a convertible from the market. The convertible is then sold by Counterparty 1 to Counterparty 2 with Counterparty 1 retaining an option on that convertible bond.

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The option allows Counterparty 1 to participate in the equity exposure and Counterparty 2 to hold the fixed income component (Figure 45). Figure 45: Anatomy of a Convertible Strip (Part 1)


Typically, Counterparty 2 will then enter into a swap exchanging the fixed rate coupon payments on the convertible for a floating rate at their cost of funding (Figure 46). Figure 46: Anatomy of a Convertible Strip (Part 2)


Counterparty 2 now effectively holds floating rate payments backed by the credit of the convertible issuer. A spread versus Libor can be backed out of these transactions so that Counterparty 2 can compare the implied credit of the original issuing company to other floating rate positions in that company’s credit. Figure 47 summarizes the transactions undertaken.

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Figure 47: Anatomy of a Convertible Strip (Summary)


In practice, Counterparty 1 and Counterparty 3 are typically combined into one entity selling a package known as a Callable Asset Swap. The process works as follows: Counterparty 2 buys the convertible from Counterparty 1 at the fixed income value of the convertible. Counterparty 2 swaps the fixed rate income stream on the convertible for a floating rate income stream with Counterparty 1 and embeds within the agreement an option to terminate the agreement and call the bonds back. Counterparty 1 retains the option to end the transaction at any time enabling them to extract any appreciation in the value of the equity option. From the perspective of Counterparty 2, it will typically view the purchase as simply that of a callable Floating Rate Note guaranteed by the company that issued the original convertible. This process is summarized in Figure 48.

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Figure 48: Convertible Stripping in the ‘Real World’


Secondary Market Implication Convertibles may be stripped by market participants who do not incorporate a call option in the transaction (and therefore lose the ability to repackage them). This can result in liquidity becoming seriously impaired. This has been particularly notable in Asia where several issues have been 50% (or more) stripped, and secondary market liquidity has correspondingly diminished.

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5.

Investing in Convertibles as an Asset Class Performance of Convertibles as an Asset Class Persistent Long-run Outperformance of Convertible Bonds Background Analysis Revisited Return, Risk and Correlation - Outstanding Long-term Convertible Performance Correlation Analysis Rationalizing Outperformance Explanations for Outperformance Caveats

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Performance of Convertibles as an Asset Class Persistent Long-run Outperformance of Convertible Bonds The analysis of the performance of convertible securities as an asset class is intrinsically complicated given the hybrid nature of the instruments involved. We summarize below some of our findings based on extensive research conducted by Ibbotson Associates in association with Goldman Sachs over the past few years. Over the period for which reliable long-run data are available (ie since the early 1970s), the total return performance of US convertibles has virtually replicated that of the S&P 500 with significantly lower risk. The total returns for convertible bonds have demonstrated a much higher correlation with the S&P 500 than with the corporate bond universe. Convertibles are useful in optimizing performance in both fixed income and equity portfolios. We highlight three possible reasons for this apparent long-run outperformance of convertible instruments: (1) exposure to a universe of significantly higher beta underlying stocks (than the S&P 500) through a period of long-run excess returns from equities, (2) ostensibly inefficient company timing in calling convertible instruments, and (3) attractive convertible pricing at issue. Background In 1992, Goldman Sachs sponsored a study of long-term convertible bond performance. The study was intended to be an objective examination of the rationale for investing in convertible bonds and aimed to compare the intuitive logic for convertible investment with the empirical evidence. The resulting article, written by Scott L. Lummer and Mark W. Riepe of Ibbotson Associates is now acknowledged as one of the seminal works on the convertible market (Convertible Bonds as an Asset Class; 1957-1992 The Journal of Fixed Income Vol. 3 No. 2, September 1993). We believe it has been a contributing factor in the growth in size and sophistication of the US convertible market over the last few years. Analysis Revisited Three years after the original study, we encountered a strong demand from our client base for a revision of the article’s data to include the market movements of the three years to year-end 1995, particularly given the bond market volatility and the equity market strength through that period. For that reason, we invited Ibbotson Associates to revisit the analysis and to update it to include the period from 1992 to year-end 1995.

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We include below summary data and conclusions in a format which mirrors that of the original report. In particular, we focus on the key return, risk and correlation data which comprised the second section of the report. Return, Risk and Correlation - Outstanding Long-term Convertible Performance The core of the data in the original analysis (Convertible Bonds as an Asset Class) compared the total return of $1 invested in a variety of asset classes between December 1956 and December 1992. Predictably, convertibles gave a total return between that of the equity market (S&P 500) and the corporate bond market for the entire period of the study. Less predictably, during the period from 1973 to 1992 (for which the most complete data on convertible market performance were available) convertibles gave a total return which actually exceeded that of the equity market with a significantly lower standard deviation. Figure 49: Growth of $1 Invested at Year-End 1956 in Convertibles

Source: Ibbotson Associates, Goldman Sachs

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Figure 50: Growth of $1 Invested at Year-End 1973


The updated analysis (Figure 49 and Figure 50) underlines the exceptional ongoing performance of the convertible asset class. There have been almost identical compound annual returns for convertible bonds (11.70%) and the S&P 500 (11.84%) from January 1973 to December 1995, with a much lower standard deviation of 12.4% for convertible bonds versus 17.3% for the S&P 500 (Figure 51 and Figure 52). Figure 51: Summary Statistics Since 1956 1957 - 1995 Compound Annual Return

Wealth Index (Dec. 1956 = $1)

10.89%

$56.32

16.37%

Convertible Bonds

8.53%

$24.33

13.84%

Long-term Corporates

7.12%

$14.62

10.84%

Intermediate-term Corporates

7.36%

$16.05

8.15%

Asset Class S&P 500


80

Standard Deviation


Figure 52: Summary Statistics Since 1972 1973 - 1995 Compound Annual Return

Wealth Index (Dec. 1972 = $1)

S&P 500

11.84%

$13.11

17.27%

Convertible Bonds

11.07%

$12.73

12.47%


9.66%

$8.34

12.44%

Intermediate-term Corporates

9.91%

$8.79

8.93%

Asset Class

Standard Deviation


In order to allow a more comprehensive examination of these numbers, Figure 53 and Figure 54 break them out into shorter time periods. We highlight in particular: (1) the large deviations away from expected returns within these smaller time periods, and (2) the fact that the total return performance of convertible bonds within the most recent period (1993-95) is consistent with longrun expectations, falling between that of the S&P 500 (15.26%) and that of intermediate-term corporate bonds (8.79%) at 11.35%. Figure 53: Risk and Return - 5 Year Increments 1957-1995 Convertible Bonds

Period

Comp. Ann Return

S&P 500

Intermediate term Bonds


Comp. Comp. Comp. Stand. Ann Stand. Ann Stand. Ann Stand. Dev. Return Dev. Return Dev. Return Dev.

1957-1962

3.19%

16.08%

1963-1967

9.36

12.67

1968-1972

0.23

1973-1977

8.88%

21.33%

4.26%

2.99%

4.46%

5.01%

12.39

13.79

0.76

2.75

0.30

3.60

17.65

7.53

10.70

6.48

7.59

5.85

9.87

6.79

10.79

-0.21

17.62

7.81

6.09

6.29

8.72

1978-1982

16.48

13.86

14.05

18.44

7.15

9.81

5.57

5.99

1983-1987

11.45

14.18

16.49

21.08

14.3

6.45

14.06

1.36

1988-1992

12.49

8.86

15.89

15.48

11.2

3.89

12.50

7.01

1993-1995

11.35

7.14

15.26

9.54

4.78

10.47

7.64

8.79


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Figure 54: Risk and Return - 5 Year Increments 1957-1995


In order to place convertibles on an equal footing with respect to risk, alphas were computed over the 1973-95 period for convertibles and long- and intermediateterm corporate bonds. The results (Figure 55) indicate that both asset classes have had returns above expectations given their level of risk. Figure 55: Convertible, Long-term and Intermediate-term Bonds: Calculation of Jensen’s Alpha and Beta 1973-1995 Beta

Beta tstatistic

1.42

0.60

32.82

0.11%

0.70

0.26

7.24

0.14%

1.47

0.18

8.46

Asset

Alpha

Convertibles

0.12%

Long-term Corporates Intermediate-term Corporates


82

Alpha tstatistic


Note. Alpha is reported in percent excess return per month. The regression is run using monthly total returns over the period 1973 - 1995. The regression is of the form: ri - rT-Bill = ai + ßi (rS&P) - rT-Bill) + E where: ri

= monthly total return on asset i

rT-Bill = monthly total return on T-Bills rS&P

= monthly total return on the S&P 500

Figure 56 shows annual returns for the S&P 500 and convertibles over the period 1973 to 1995. In simple terms, it demonstrates that convertibles and common stocks typically move together, but with yearly fluctuations tending to be lower for convertibles. The correlation between convertible and S&P 500 monthly returns over the January 1973 to December 1995 period is 0.89. Figure 56: Convertible Bonds and S&P 500 Yearly Total Returns 19731995


Figure 57 provides summary statistics for convertible bonds and stocks in months when the S&P 500 rose and fell. Convertibles tend to be up (down) when stocks

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are up (down), but the magnitude of the monthly total return is smaller for convertibles. Figure 57: Analysis of Monthly Total Returns in Up and Down Markets 1973-1995 In Months when the S&P 500:

Increases S&P 500

Convertibles

Decreases S&P 500

Convertibles

Arithmetic Mean Rtn.

3.70%

2.57%

-2.99%

-1.44%

Standard Deviation

2.99%

2.17%

3.08%

2.35%

Number of Months

166

166

110

110


Correlation Analysis One of the key insights of mean-variance optimization is that the addition of a risky asset to a portfolio can reduce portfolio risk if the asset has low correlations with the other portfolio assets. Figure 58 presents the correlations of monthly total returns for convertibles with the major US asset classes. The results indicate that convertibles have been highly correlated with both large and small cap stocks, but much less correlated with the various fixed income asset classes. This implies convertibles will provide effective diversification in fixed income-oriented portfolios.

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Figure 58: Correlation of Convertible Bonds with Other Major US Asset Classes Correlation with Convertible Bonds Large-Capitalization Stocks

0.89

Small-Capitalization Stocks

0.85

Long-term Treasury Bonds

0.44

Intermediate-term Treasury Bonds

0.37

Treasury Bills

-0.06

Long-term Corporate Bonds

0.47

Intermediate-term Corporate Bonds

0.53

Mortgage-backed Securities

0.40

Real Estate

-0.08

Note. Correlations are generally calculated using monthly total returns over the period 1973 to 1995. The exceptions are mortgage-backed securities, which use the period 1976 to 1995, and real estate which uses quarterly returns for the period March 1978 to September 1995. Source: Ibbotson Associates, Goldman Sachs

Mean-variance optimization derives the security or asset class weight for a portfolio that provides the maximum expected return for a given level of risk, or, conversely, the minimum risk for a given expected return. Mean-variance optimization requires estimates of expected return, standard deviation and crosssecurity correlation. Estimates of these factors are given in Figure 59 and Figure 60. To estimate the long-run expected return on convertible bonds we use the model: E[rconv] = Rf + DP + OP where: E[rconv] Rf DP OP

= = = =

Expected Return on the Convertible Risk-free Rate Default Premium Option Premium

1. Risk-free Rate. The yield on the non-callable US Treasury 20-year bond as of December 1995 (6.03%) was used as the risk-free rate. A long rather than a

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short maturity bond was used because the requirement was for a riskless security with a relatively long-term and stable yield.

2. Default Premium. Clearly there is a default risk attached to convertible instruments and their yields must be high enough to provide additional compensation to cover expected losses from default. In order to estimate this risk (or the default premium) the study takes the difference between the arithmetic means of annual total returns for long-term corporate and long-term Treasury bonds over the longest period for which reliable data are available. Using the years 1926 to 1991, the estimated default premium is 5.7% - 5.1% = 0.6%. This approach is based on the premise that convertibles are a class of corporate bonds, although clearly the average credit quality of the convertible universe may differ to some extent from that of the straight corporate universe.

3. Option Premium. The option premium represents the difference between what investors are willing to pay for a convertible instrument and a nonconvertible one with identical characteristics. The option premium is estimated by assuming that investors adjust their long-run expectations to what is realizable. The observed difference in the arithmetic means of annual total returns on straight and convertible bonds since 1973 has therefore been used as our estimate of option premium for the purposes of analysis. Figure 59: Estimates of the Long-Run Expected Return and Standard Deviation for Convertible Bonds and Major US Asset Classes Asset Class Convertibles

Expected Return 8.95%

Standard Deviation 12.47%

Large-Capitalization Stocks

13.39

20.42

Small-Capitalization Stocks

16.86

34.37

Long-term Treasury Bonds

6.03

12.22

Intermediate-term Treasury Bonds

5.76

7.01

Treasury Bills

4.15

2.75

Long-term Corporate Bonds

6.88

11.80

Intermediate-term Corporate Bonds

6.12

8.43

Mortgage-backed Securities

6.98

10.52

Real Estate

6.71

15.15


Given the above data it is clearly possible to determine the percentage of a portfolio which should be allocated to convertible bonds and indeed, in the original report (Convertible Bonds as an Asset Class), the allocation to

86


convertibles in a minimum variance portfolio was calculated as a provocative 5% (the updated underlying numbers are largely in line with the previously calculated series and it seems reasonable therefore to infer a similarly high convertible allocation). Figure 60: Correlation Matrix for Convertible Bonds and Major Asset Classes

Conv.

LongLarge- Small- term Cap. Cap. Treas. Stocks Stocks Bonds

Inter.term Treas. Bonds

Treas. Bills

Longterm Corp. Bonds

Convertibles

1

Large-Cap. Stocks

0.89

1

Small-Cap. Stocks

0.84

0.81

1

Long-term Treas. Bonds

0.62

0.49

0.21

1

Inter.-term Treas. Bonds

0.60

0.41

0.14

0.92

1

Treas. Bills

0.02

-0.03

0.01

-0.04

0.21

1

Long-term Corp. Bonds

0.70

0.61

0.35

0.94

0.91

-0.07

1

Inter.term Corp. Bonds

Mortback Secur Real ities Est.

Inter.-term Corp. Bonds

0.73

0.61

0.39

0.91

0.95

0.13

0.97

1

Mort.-backed Securities

0.60

0.48

0.11

0.89

0.92

0.08

0.96

0.93

1

Real Est.

0.27

-0.03

0.48

-0.07

0.02

0.24

0.04

0.12

-0.13

1


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Rationalizing Outperformance Explanations for Outperformance There are a number of possible explanations for the long-run outperformance of convertibles as an asset class: 1. Pricing at Issue. Using conventional bond plus warrant valuation models, convertibles typically appear underpriced at issue and the unwinding of this undervaluation may be a driver of strong long-term performance. This undervaluation should probably be expected given that: (i) convertible issuance will often cause a short-term dip in the share price and (ii) secondary share offerings are typically priced at a discount anyway. It may also be the case that ‘underpricing’ is a cost of entry to the market given the size of many convertible offerings. It is certainly the case that instruments which appear undervalued from the investor perspective may likewise be attractive from the issuer perspective given the tax treatment of the coupon payments on a convertible bond. That is to say, an issuing company confident of the long-run strength of its share price (ie of conversion) may prefer to issue a convertible bond in order to secure tax-deductibility on their coupon payments. This differential between investor valuation and issuer valuation is one of the reasons we are confident about strong future performance of the convertible market. 2. Callability. Companies rarely call their convertibles at the precisely ‘optimum’ moment as assessed by investor theoretical models. This apparent inefficiency typically allows some additional performance versus theoretical expectation. Again, however, this windfall for the convertible holder does not necessarily reflect issuer inefficiency given their different considerations. Specifically, the decision not to call a callable instrument may be the result of: (1) a desire to avoid dilution; (2) an unwillingness to allow convertible holders a free put on their stock in the period between the call announcement and the call date; or (3) rating agency and/or balance sheet considerations. 3. Higher Betas. The high total returns of US convertibles over the last 20 years may in part reflect exposure to a universe of significantly higher beta underlying stocks (than the S&P 500) in a period of long-run excess returns from equities.

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Caveats Analysis of a relatively small and under-researched asset class gives rise to difficulties in the generation and assimilation of data. Among the notes of caution we would highlight: 1. A Dynamic Market. The profile of the convertible market will change over time as the market moves in and out of the money. There is a danger that a single index for convertible performance will shift in profile (eg average premium) over time. The one point we would make in response to that is that given the long-run nature of the data, the long-term market profile may be relatively consistent. 2. Data Reliability. Extending our analysis back 40 years involves using a collection of data series, the reliability of which is subject to question. We would caution that the data from before 1973 in particular is the best available rather than necessarily being of high quality in its own right.

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6.

Issuing Convertible Securities The Issuer’s Perspective The Attraction of Convertible Financing The Theoretical Rationale for Convertible Issuance Cost of Capital Fulfilling Financing Objectives - Why Issue a Convertible? Lower Cash Cost Potential Deferred Sale of Equity in the Future at a Premium Tax-Deductible Interest Rating Agency Considerations Reduction of Dilution Monetization of an Equity Investment Ease of Issuance Privatization Ability to Finance in Size Incremental Investor Demand Managing the Issuer Equity Account Signaling Deciding on the Appropriate Structure The Decision Process ACES YES Convertible Preferreds Vanilla Convertible Debt Discount Convertible Debt Zero Coupon Convertible Debt New Issue Options Identifying the Prospective Issuer

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The Issuer’s Perspective The Attraction of Convertible Financing Convertible securities are the most flexible financing instruments in the securities market and there are numerous factors driving the increasing popularity of convertible issuance around the world. We highlight some of the most important below. Convertibles can offer the opportunity to: Issue subordinated debt capital in large size; Minimize EPS dilution versus debt or equity; Access an alternative (and fast-growing) investor base; Minimize balance sheet impact through the issuance of preferreds; Achieve the most tax-efficient combination of low balance sheet impact and tax-deductibility on coupon payments; and Finance quickly with low requirements on management time. The Theoretical Rationale for Convertible Issuance It is sometimes erroneously stated that vanilla convertible debt financing gives issuers the best of both worlds because: The conversion price is usually set at a premium to the current stock price, so that if conversion takes place the issuer will get a better price for its stock than if it simply sold shares now. The coupon cost of a convertible is less than that of straight debt, so that if conversion does not take place the company has issued cheap debt by issuing a convertible. The problem with this line of reasoning is that it is highly selective. If the issuer’s share price does rise so much that conversion takes place in the future, then a convertible will indeed have been a better form of financing than a sale of stock today at current prices, but better still in terms of maximizing shareholder value would have been a sale of straight debt. Conversely, if conversion fails to take place, then issuing a convertible would prove to have been better than raising straight debt, but better still would have been a pure sale of equity. Rather than considering the issuer’s investment rationale on an ex-post basis, a better approach is to consider the issuer’s decision on an ex-ante basis, when the issuer cannot be certain of the outcome.

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Cost of Capital Figure 61 illustrates the relative future cost of capital to an issuer of a vanilla convertible security under different assumptions of share price growth. In this figure, the cost of straight debt capital is defined as the yield (interest) cost of financing. Typically, this yield cost is higher than either the yield cost of convertible debt or the dividend cost of equity financing. However, from the perspective of existing shareholders, a sale of further stock has an additional cost if the share price subsequently grows, since it implies that equity has been sold too cheaply. Figure 61: Relative Cost of Capital of Differing Financing Alternatives

Note. The ‘equity’ line crosses above 0% annual stock price growth to reflect a notional stock dividend yield Source: Goldman Sachs convertible research

Looking at the relative outcomes in Figure 61, it can be seen that if the company’s share price grows by between x% and y% during the period under consideration then convertible financing will be the cheapest alternative. Thus, any company that believes that its share price growth will be in this range should consider convertible financing. More plausibly, any issuer that is uncertain about the future of its stock price should certainly consider using convertibles as part of a portfolio of financing alternatives.

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This is just the beginning of the cost of capital analysis, however, and Figure 62 extends it to incorporate a far broader array of equity-linked securities. Figure 62: A Broader Cost of Capital Comparison


Most importantly, in addition to the purely quantitative reasons there are compelling qualitative reasons for a company to issue convertibles. Indeed, it would be fallacious to state that companies select financing alternatives based on cost of capital analysis alone. The reductio ad absurdum of this perspective would be that companies issue equity solely because they have a negative view on their own business prospects. We review some of the reasons companies are increasingly using convertible financings in the following section.

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Fulfilling Financing Objectives - Why Issue a Convertible? Lower Cash Cost At the simplest level, companies can reduce their straight borrowing rate by issuing convertible securities. For example, a company able to issue 10 year debt in the straight market at 150 bps over government rates might be able to finance at 50 bps less than government rates if it issued a convertible. There would, of course, be an opportunity cost attached to such a strategy, ie if the share price has appreciated above the conversion price at maturity, it would probably have been cheaper for the company to have issued straight debt rather than a convertible. Potential Deferred Sale of Equity in the Future at a Premium A company needing to raise money in the short term but believing its share price will move higher in the longer term may use the issuance of a convertible structure to get a potentially higher price for its stock at issue than it would otherwise receive through a secondary stock offering. Tax-Deductible Interest Under most tax jurisdictions, dividends are paid out of after-tax income, making common stock and preferred dividends expensive; in contrast, interest expense on debt is tax-deductible. One advantage to the issuer of convertible debt in relation to common stock is that until debt is converted, its expense is deductible. This can make the after-tax cash expense of a convertible compare favorably to the dividend expense of the shares into which it may be converted. This characteristic also helps to account for some companies apparent inefficiency (from an investor perspective) in calling convertibles. For any debt issued at a discount to its maturity value, the yield to maturity is greater than the current yield. In many countries, the yield to maturity rate is the rate at which the corporation can claim and deduct interest expense. Rating Agency Considerations The issuance of convertible debt allows a company to issue subordinated debt capital. Given that debt interest expense is generally tax deductible, the cash flow to an issuer is always better with convertible debt than with convertible preferred. A company might issue preferred, however, in order to improve its balance sheet ratios and, at the margin, to enhance its ratings. Because preferreds often have no maturity (and thus no fixed obligation to return the principal to the investor) and no binding requirement to make fixed payments at fixed intervals, rating agencies consider convertible preferreds to be a less onerous balance sheet burden than debt obligations.

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Reduction of Dilution Because convertibles allow companies to potentially issue equity at a premium, the dilution to existing shareholders is significantly less than if the company had issued straight equity. In addition, the management of a closely held company may use the issuance of a convertible to defer the dilution of voting rights in their company. In general, the primary earnings per share of a company will not take into account any additional shares that are potentially created by conversion of an outstanding convertible, as long as the convertible was originally issued with a significant conversion premium. However, a company will also report fully diluted earnings per share using the number of shares outstanding assuming all convertibles are converted. Monetization of an Equity Investment Companies with substantial cross-holdings in other companies will often seek the opportunity to monetize these investments. Monetization by outright sale may not be attractive either because the share price is too low, or the company wishes to avoid immediate realization of a capital gain. The issuance of an exchangeable may help an issuer resolve both of these issues. Ease of Issuance Under certain scenarios convertible issues can even be completed within a few hours of launch. This type of transaction is often known as an ‘overnight’ convertible given the ability for issuers to announce the deal after the market close and then to price and allocate before the market opening the next morning. Privatization Exchangeables can also be a useful tool for governments in their privatization programs. Two recent transactions have seen issues from the Italian government and the Pakistani government with the respective governments as guarantor and the privatized company as exchange property. We review Privatization Exchange Notes (PENs) in more detail when discussing exchangeables in Chapter 3. Ability to Finance in Size The size and growing sophistication of the market allows the quick sale of very large convertible issues. In particular, the unique structure of convertible securities allows them to appeal to investors from multiple investor bases allowing potentially larger deals than from the straight debt or straight equity markets (especially for weaker credits).

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Incremental Investor Demand Convertible issuance allows the issuer to reach a wider investment audience since the issuance of a security with a higher income and different capital risk-reward profile may appeal to investors who would not (or could not) otherwise invest in the issuer’s common stock. Some of the most important convertible market investors are drawn from an essentially fixed income background and the issuance of a convertible may allow them to introduce equity exposure to portfolios without dramatically increasing overall portfolio risk. Issuers who have recently raised equity capital in either a primary or secondary offering may find it easier to raise further capital by widening their investor base through a convertible offering rather than by returning to the equity market. Conversely, many issuers who would like to raise straight debt may find that market closed to them because their credit rating is too low. The convertible market, which by its very nature is more accustomed to dealing with a greater range of credits, may be more accommodating. Managing the Issuer Equity Account Issuers view convertibles as one layer of a desired overall capital structure. Convertibles can be an attractive component of this structure offering the combination of a lower yield versus debt with a potential future issue of common stock at a premium. Signaling Convertible issuance sends a positive signal to equity markets. An issuer typically hopes that a convertible will convert and with a vanilla convertible this will only occur if the share price rises above the conversion price.

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Deciding on the Appropriate Structure The Decision Process There are clearly multiple factors at work in making any hybrid equity financing decision. For six of the most familiar securities, we review below the key factors to be considered. ACES The key advantages of an ACES structure from the issuer perspective include the substantial equity credit achieved and the retained upside in the stock resulting from the conversion premium. Less attractive is the overall cost of the instrument versus straight convertible preferred in the event of substantial stock price appreciation. Figure 63: Issuer Checklist for ACES* Security Type

Preferred stock

Conversion Feature

Mandatory conversion into common stock

Accounting Treatment

Preferred stock on balance sheet. Same dilution as common.

Tax Treatment

No deductibility

Equity Credit

Mandatory conversion means high degree of rating agency equity credit

* ACES may also be issued as debt with a tax-deductible coupon payment. Source: Goldman Sachs convertible research

YES Similarly YES achieves substantial equity credit and retains all of the stock upside in the event of stock price appreciation beyond the cap level. It is however, less attractive than straight preferred if the stock price appreciates only up to a certain level. Figure 64: Issuer Checklist for YES Security Type

Preferred stock

Conversion Feature

Mandatory conversion into common stock


Preferred stock on balance sheet. Same dilution as common.

Tax Treatment

No deductibility

Equity Credit

Mandatory conversion means high degree of rating agency equity credit


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Convertible Preferreds We identify three key advantages to issuers of convertible preferreds:

1. A broad based market with a high level of investor familiarity; 2. Lowest cash cost of any security receiving equity credit; and 3. Retained upside in the stock due to the conversion premium. Less attractive are the cost versus straight preferred in the event of stock price appreciation and the risk of a hung (ie non-converted) convertible in the event of stock price weakness. Figure 65: Issuer Checklist for Convertible Preferreds Security Type

Preferred stock

Conversion Feature

Investor option to convert into common stock


Preferred security on balance sheet. Typically, less initial dilution than common stock due to conversion premium.

Tax Treatment

No tax-deductibility

Equity Credit

Redemption feature can be structured to enhance equity credit from rating agencies (stock settlement)


Vanilla Convertible Debt We identify four key advantages to issuers of vanilla convertible debt:

1. Reduced cash cost of financing arising from the sale of the embedded equity option;

2. Established market with very broad investor demand; 3. Attractive route for sub-investment grade credits to raise long-term fixed rate debt; and

4. Tax-deductibility of coupons. On the negative side, vanilla convertible debt is less attractive than straight debt if the stock price rises substantially. It also receives no equity credit from the rating agencies. Figure 66: Issuer Checklist for Vanilla Convertible Debt Security Type

Debt

Conversion Feature



Debt on balance sheet. Less dilution than common.

Tax Treatment

Full tax-deductibility

Equity Credit

None


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Discount Convertible Debt The three key advantages of discount convertible debt are:

1. Accretion of the instrument’s effective conversion price over time; 2. The OID amortization is generally tax-deductible; and 3. Low cash cost. Less attractive is the fact that it is not equity for rating agency purposes and it will appear expensive versus straight debt if the share price rises substantially. Figure 67: Issuer Checklist for Discount Convertible Debt Security Type

Debt

Conversion Feature




Tax Treatment

Full tax-deductibility, generally at yield to maturity

Equity Credit

None


Zero Coupon Convertible Debt The three key attractions of zero coupon convertible debt are: 1. Accretion of the instrument’s effective conversion price over time; 2. The current tax benefits of the OID amortization; and 3. Zero cash cost. On the negative side, it is not equity for rating agency purposes and the (typical) inclusion of investor put features may shorten effective maturity. Figure 68: Issuer Checklist for Zero Coupon Convertible Debt Security Type

Debt

Conversion Feature




Tax Treatment

Current deductibility of accretion, generally at yield to maturity

Equity Credit

None


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New Issue Options In Figure 69, we summarize some key structural guidelines for an issuer of a convertible security. Figure 69: New Issue Summary Information

Probability of Conversion

Balance Sheet Treatment

Cash Cost

Rating Agency Equity Credit

Zero

Debt

Medium

Zero

Very Low

Debt

Zero

Low

Low

Debt

Very Low

Low

Medium

Debt

Low

Low

High

Capital

High

High

Mandatory Convertibles

Certain

Capital

Highest

High

Straight Equity

Certain

Equity

Low

Full

Straight Debt Zero Coupon Convertible Discount Convertible Convertible Debt Convertible Preferred


Identifying the Prospective Issuer We review below in general terms some of the factors which can influence the suitability of a company to issue a convertible:

1. Dividend Yield. A company with a relatively low dividend payout policy is generally better positioned to issue a convertible security given that investors typically require that coupons (or yield to maturity) exceed the dividend yield on the common stock, to compensate them for stock purchase at a premium.

2. Stock Volatility. The higher the stock volatility, the greater the value of the option embedded in a convertible.

3. Credit Rating. Investors clearly focus on the credit quality of a prospective issuer and on the implicit downside protection of an instrument.

4. Stock Borrowability. Widely available stock borrow enhances the ability of the market to provide a liquid market (by hedging outright holdings where appropriate).

5. Equity Story. A good long term case for future share price appreciation enhances the salability of a new convertible security.

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7.

Valuing Convertible Securities as Derivatives Theoretical Approaches to Convertible Valuation Theoretical Valuation Creating a Theoretical Model Creating The Binomial Tree The Credit-Adjusted Discount Rate Summary Further Issues Valuing a Hypothetical Convertible Applying the Methodology Using The Model To Hedge

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Theoretical Approaches to Convertible Valuation Theoretical Valuation Valuation of convertible securities is increasingly driven by theoretical analysis. Certainly, investors seeking a more sophisticated valuation technique should consider the use of theoretical models. We have adapted to more generic application (below) a piece published by the Goldman Sachs Quantitative Strategies Group in 1994. Creating a Theoretical Model The owner of a convertible bond has the right to receive future coupon and principal payments in exchange for stock, subject to certain call and put provisions as outlined in Chapters 1-2. Although there are several sources of uncertainty that affect the value of convertibles, matters are simplified below by assuming that the only source of uncertainty is the future price of the underlying stock. It is assumed that everything else (interest rates and the volatility of the stock, for example) is known with certainty. Stock price uncertainty is generally the major source of option value in most convertibles. More specifically, the following assumptions are made:

1. The distribution of future stock prices is lognormal with known volatility. 2. All future interest rates (the riskless rate, the stock loan rate and the issuer’s credit spread) are known with certainty.

3. All the information required about default risk is contained in the credit spread for the issuer’s straight bonds (see below how the credit spread is used in calculating present values of future convertible cash flows). Using these assumptions, the valuation method developed by Black and Scholes for ordinary options is applicable to convertible bonds. Specifically:

1. A convertible bond can be hedged by shorting the underlying stock to create an instantaneously riskless hedge; and

2. A convertible can be valued by calculating its expected value over all future stock price scenarios, provided they are consistent with the known forward prices of the stock and its volatility. Creating the Binomial Tree The Cox-Ross-Rubinstein method of formulating the Black-Scholes equation begins by building a binomial tree of stock prices in a ‘risk-neutral’ world. In this risk-neutral world, any security has an expected total return equal to the riskless rate less any rebates for borrowing securities. Each node in the tree represents a possible stock price at a specific time. Figure 70 shows one period of the stock

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tree extending over one short valuation time step of duration t. The whole tree, of which Figure 70 is merely a part, starts on the valuation date and ends at the maturity of the convertible. Figure 70: One-period Stock Tree


The stock starts at price S. After time t elapses, the stock can move to either Su or Sd with equal probability and the difference between Su and Sd is determined by the volatility of the stock. The mean of Su and Sd is the forward price of the stock after time t. After creating the tree of future stock prices, a corresponding tree of future convertible bond prices can be built. The value of the convertible tree node is calculated by starting at maturity, where its value is known with certainty, and then moving backwards in time down the tree, period by period, to calculate the value at earlier nodes. Figure 71 shows the corresponding one-period convertible tree. Figure 71: One-period Convertible Tree


Let V be the value of the convertible bond at the start of the period. V is found by comparing the choices available to the issuer and the investor, assuming that each

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behaves in a rational manner and that the only possible convertible values one period in the future are Vu and Vd. The holding value H of the convertible at the start of the period in a binomial model is the expected present value of Vu and Vd, plus the present value of any convertible coupons paid during this period. H is the expected value the investor can realize by waiting for one further time period without converting, assuming no provisions are applicable during that time. We review below how to calculate the value V of the convertible at the current node for all combinations of provisions that may be in effect: 1. No active call or put provisions. The investor can either hold the bond for one more period or convert it to stock. Therefore, he will choose to make V the maximum of the holding value H and parity. 2. The convertible can be put at a price P. The investor can hold, convert, or put the bond for cash equal in value to P plus accrued interest. He will choose to make V the maximum of holding value H, parity, and the put value. 3. The convertible is both callable at price C and putable at price P. The issuer will call the bond when the call value (defined as C plus the accrued interest) is less than the holding value H. If the bond is called, the investor can still choose whether to put the bond for the put value, convert it to stock, or accept the issuer’s call. V is the minimum of holding value H and call value. Note that put and call provisions allow the investor to receive accrued interest. An investor who converts will forfeit the accrued interest. The Credit-Adjusted Discount Rate The holding value H of the convertible at any node in the tree is the sum of the present values of the coupons paid over the next period, plus the expected present value of the convertible at the two nodes at the end of the period. The next issue is to establish what discount rate should be used to calculate these present values. We include below one possible methodology for deriving the credit-adjusted discount rate. For an ordinary option that exercises into stock, the appropriate discount rate is the riskless rate r, because hedging the option with stock results in a riskless investment over a short time period. However, the riskless rate is not entirely appropriate for discounting these payoffs because convertible bonds pay coupons and return principal, which, unlike stock, are both subject to default. First, consider the two extremes of high and low stock prices. If, at the next node, the stock is far above the conversion price, the conversion option will be deep in the money and is certain to be exercised. Under this scenario, the appropriate discount rate is the riskless rate r, because the investor is certain to obtain stock with no default risk.

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Alternatively, if the stock price at the next node is far below the conversion price, the conversion option will be deep out of the money and will certainly not be exercised. In that case, the investor owns a corporate-grade fixed income instrument that will continue to pay coupons and principal. The appropriate discount rate, d, is the ‘risky rate’ obtained by adding the issuer’s credit spread to the riskless rate. To summarize, at high stock prices, where eventual conversion is virtually guaranteed, the appropriate discount rate is r; at low stock prices, where eventual conversion is overwhelmingly unlikely, the appropriate rate is d. At intermediate stock prices, the credit-adjusted discount rate, y, is used. Let p be the probability at a given node that the convertible will convert into stock in the future. Then (1-p) is the probability that it will remain a fixed-income bond. The convertible at any node is effectively a weighted mixture of defaultfree stock and a default-prone corporate bond, with p specifying the weighting factor. The credit-adjusted discount rate should reflect the proportion of riskless and risky assets contained in the convertible. y is defined as the weighted mixture of the riskless and risky rates, where the weighting factor is p; that is, y=p*r+(1p)*d. The value of p is easy to find on a binomial tree and the methodology is explained below. The credit-adjusted rate y is equal to r when p=1 and conversion is certain. It is equal to d when p=0 and conversion is impossible. By using y for discounting, a credit spread can be assigned to the convertible that moves smoothly between zero and the issuer’s credit spread, depending upon how likely it is that the convertible ultimately converts. Summary We list below a short summary of the steps followed to construct our binomial model for valuing convertible bonds. 1. Build a Cox-Ross-Rubinstein stock price tree that extends from the valuation date to the maturity of the convertible. In building the tree, ensure that at each time level the stock has the appropriate assumed volatility and that the average stock price matches the stock’s forward price. 2. At maturity, compute the value of the convertible bond as the greater of its fixed income redemption value and its conversion value. Define the probability of conversion to be one at nodes where it pays to convert and zero otherwise.

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3. Move backwards in time down the tree, one level at time. At each node within each level, define the conversion probability as the average of the probabilities at the two connected future nodes. Compute the credit-adjusted discount rate at each node using this conversion probability. Then compute the holding value H at each node as the sum of the cash flows occurring over the next period and the expected bond values of the two nodes one period in the future, discounted at the credit-adjusted discount rate. Further Issues Convertibles are complex securities. They incorporate within one instrument many issues, including the question of how to model credit risk. The model outlined above is a simplified attempt to incorporate some of a convertible security’s most important properties. It disregards several complexities touched upon below in the interest of having a relatively straightforward methodology that can be used with easily available security prices, interest rates and credit ratings. Issues worth bearing in mind include the following: A convertible with parity much greater than its face value, and therefore certain to convert at some time in the future, has a credit-adjusted discount rate equal to the riskless rate. In this case, our model discounts the coupons paid until conversion at the riskless rate, as though they have no default risk. It is possible to develop variants of our model in which these coupons are nevertheless discounted at the ‘risky’ rate. An at the money convertible from an issuer with a sizable credit spread can decrease in value when volatility increases. In options parlance, it can have negative vega. This nonintuitive result occurs because an increase in volatility has two effects. First, it makes the expected payoff from conversion greater. Second, it increases the probability of default, which lowers the convertible’s value. Sometimes the latter effect outweighs the former. A convertible bond is a derivative claim on the company’s stock and the stock itself can be regarded as a derivative claim on a company’s assets. From this perspective, a convertible is really a compound derivative claim on the assets of the issuer, and it is natural to assume that the distribution of future asset values is lognormal. If this is true, however, distribution of future stock prices cannot be lognormal, contrary to the assumptions of our model. Corporations may default on the future payments of interest and return of principal of their bonds. The value of a convertible depends, therefore, upon the current and future credit-worthiness of the issuer. A convertible may therefore be approached as a credit derivative with the value of the derivative depending upon the volatility of the changes in the credit spread. In the model outlined above, it is assumed the credit spread remains constant throughout the convertible’s lifetime.

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Valuing a Hypothetical Convertible Applying the Methodology We now illustrate how the model can be applied by valuing a hypothetical convertible bond, described in Figure 72. A large credit spread of 500 basis points is used to make its effect on the credit-adjusted discount rate easily observable. In order to display the full tree from valuation date to maturity, the time steps between periods were taken as one year in length. Although this makes the distribution of stock prices unrealistically coarse-grained, it makes drawing and interpreting the tree easier. A computer version of the model would use much smaller steps in order to achieve greater accuracy. Figure 72: Hypothetical Terms Principal

$100

Coupon

10% per year

Maturity

5 years

Conversion Ratio

1

Calls

$115 in year 2, declining by $5 every year until maturity

Puts

put at $120 in year 3

Current stock price

$100

Stock dividend rate

0%

Volatility

10% per year

Riskless rate

5% per year

Stock loan rate

5% per year

Credit spread

500 basis points

Note. Bond coupon, stock dividend yield and all interest rates are annually compounded. Source: Goldman Sachs convertible research

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Figure 74 shows the stock and convertible trees with one-year time steps. Each node on the stock tree shows the stock price, while each node on the convertible tree shows the convertible value and a letter code to indicate the action that has been taken at that node. Figure 73 explains the letter codes. The conversion probability used to calculate the credit-adjusted discount rate is also shown at each node. Figure 73: Letter Codes X

Investor converts to stock

P

Investor exercises put

C

Issuer exercises call

H

Investor holds convertible for one more period

R

Issuer redeems convertible at maturity


We now turn to look at some specific nodes and to show how the values associated with them on the trees were obtained. At t=0, the stock has a value of 100 and after one year, it either moves up to 115.47 or down to 94.53. These moves correspond to a one year return volatility of 10% and an average price of $105, exactly the forward price of the stock after one year. Now look at the convertible bond tree. At maturity in year 5, the convertible bond pays out 110 (principal plus accrued interest) if the investor does not convert into stock. Therefore, at each node, the bond is either worth the maximum of the stock price at the corresponding node on the stock tree or 110. At those nodes where the maximum is the stock price, the conversion probability is 1.0. In these cases, the node’s letter code is X to indicate conversion, and the credit-adjusted discount rate is the riskless rate (5%). At those nodes where the maximum is 110, the conversion probability is 0.0, the letter code is R for redemption, and the creditadjusted rate is the riskless rate (5%) plus the credit spread (500bp), or 10%. Now look at the stock node with the lowest price (79.87) in year 4. The corresponding convertible node in year 4 can evolve into up and down nodes at maturity that are each worth 110 and have a code R with a conversion probability of 0.0. The credit-adjusted discount rate at each of these nodes is 10%. Therefore, the expected present values over these two nodes is (0.5)*(110/1.1) +(0.5)*(110/1.1) = 100. The holding value of the convertible at the lowest stock node in year 4 is calculated by adding the coupon worth 10 that is paid at the start of the year to give a holding value of 110.

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Figure 74: Binomial Trees for Valuing the Convertible Bond


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Since the call value (including accrued interest in year 4) is 115, the issuer will not call the bond. There is no applicable put in year 4 and converting to stock yields a value of 79.87. Therefore, the investor maximizes his value by holding the convertible. The convertible’s theoretical value at this node is 110 with a letter code H. The conversion probability at this node, at which the bond is not converted, put or called, is the average of its values at the up- and down-nodes, namely 1.00. The corresponding credit-adjusted discount rate is 10%. As a final example, look at the stock node with price 103.19 in year 3. On the convertible tree, the holding value at the corresponding node is given by the sum of: (1) the coupon paid at the start of the year 3 and (2) the expected value of the convertible at the two connected up- and down-nodes in year 4, each discounted at the credit-adjusted rate. The up-node in year 4 has a value of 119.15, with a conversion probability of 1.0. The corresponding credit-adjusted rate for discounting the up-value is 5%. The present value of 119.15 at this rate is 113.48. Similarly, the down-node’s conversion probability is 0.5. Therefore, the credit-adjusted rate at the up-node is (0.5)*(5%)+(0.5)*(10%) = 7.50%. The present value of 113.64 at this rate is 105.71. The expected present value of the up- and down-nodes is 109.60. The holding value includes a coupon worth 10, to give a total of 119.60. However, the investor has the right to put the bond for the put price ($120) plus accrued interest ($10), a total of $130. Since this is worth more than holding the bond for one more year, the investor will exercise the put, and the value of the convertible at this node is $130. The conversion probability here is reset to 0.0 because the convertible was put and the credit-adjusted rate is 10%. This procedure can be repeated at all nodes in the tree, working from maturity to the present, to compute the value of the convertible in year 0 when the stock price is 100. Using the Model to Hedge Let us assume a convertible trader finances the purchase of the convertible by borrowing at his cost of funds. To hedge the convertible’s stock price risk, he maintains a short position of Δ shares of the underlying stock, where Δ is the model’s value for the sensitivity of the convertible’s value to stock price changes. The funds from the short stock position are maintained in an escrow account where they earn the stock loan rate. The trader now owns a portfolio consisting of a long position in the convertible bond and a short position in stock. In theory, this portfolio is hedged against small stock price moves. Any income generated by convertible coupons and the short stock position after paying for the convertible’s financing is used to reduce the amount of borrowed capital.

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The trader will also need to hedge against changes in interest rates by computing the value of the convertible’s sensitivity to interest rate changes. There are three independent types of interest rates to be considered: the riskless rate, the stock loan rate, and the credit spread. The riskless rate and the stock loan rate usually move more or less in tandem and can both be hedged using Treasury bonds of maturity comparable to that of the convertible. For callable convertibles, using Treasuries with maturities near the first call date is more logical. The issuer’s credit spread can vary independently of Treasury rates. If there are outstanding straight bonds of the issuer with similar terms, they will have sensitivity to both the Treasury rates and the credit spread; a trader can then combine them with Treasury bonds to offset the risks due to changes in both types of rates. Unfortunately, such straight bonds often do not exist because companies frequently issue convertibles as a substitute for straight debt. In that case, hedging exposure to credit risk is difficult.

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8.

Convertibles in the Euromarket Structure of the Euroconvertible Market Definition Form and Taxation Settlement Regulation Governing Law Transaction Costs and Liquidity Ownership Restrictions: ‘Seasoning’

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Structure of the Euroconvertible Market Definition The Euroconvertible market is an international, over-the-counter market for convertible securities. The following features distinguish it from other convertible markets: Securities are offered by an international syndicate to investors in more than one country; Securities are denominated in a eurocurrency (a eurocurrency is a liability of a bank held outside the country where that currency is legal tender); Securities are traded on an over-the-counter basis; Dealers trading in Euroconvertibles are subject to the rules of the ISMA (the International Securities Market Association); and Coupon payments are generally made without deduction of any withholding taxes at the source. Form and Taxation Euroconvertibles are usually available in both bearer and registered form, with bearer form being more common. Interest income from Euroconvertibles in bearer form is generally paid without any withholding tax deductions. There are no stamp duties or other transaction taxes payable on Euroconvertible trades. Settlement Settlement usually occurs three business days after a transaction via one of the two principal clearing houses: Euroclear in Brussels or Cedel in Luxembourg. Physical delivery outside the two houses is possible, although becoming increasingly rare. Book entry within the registers maintained by the clearing houses is standard practice. Regulation Euroconvertible market practices are in the first instance regulated by the Zurichbased International Securities Market Association (ISMA). This is a selfregulatory organization comprised of over 800 international securities houses from 40 different countries which imposes a series of regulations on its members in order to promote an orderly, well-functioning market. ISMA has been in existence since 1969 and has, among other things, been responsible for the establishment of uniform market practices which now govern nearly all transactions in international securities and for the introduction of a standard method of calculating yields on these instruments.

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Governing Law Euroconvertible indentures (the legally binding agreement between the issuer and the convertible holders which details the rights and obligations of each party) from US, UK and French issuers are usually governed by the laws of their own country. Other Euroconvertible indentures are typically governed by either US (usually State of New York) or English law. Transaction Costs and Liquidity There are typically no commissions and no centralized collation of prices in the Euroconvertible market. Market makers can set their own spread between their bid and offer prices and this effectively constitutes the investor’s transaction costs. Spreads for liquid issuers are typically in the region of one quarter to one point. The liquidity of any convertible will be primarily a function of the following factors: The size of an issue. The larger the size, the greater the market maker’s ability to make markets for a larger volume of a security. The ability to hedge risk. The more that a market maker can offset the risks of altering its convertible inventory in response to customer flows (for example by shorting stock, fixed income securities or a mixture of the two against a long convertible position), the tighter will be the likely bid to offer spread. The liquidity of the underlying stock. The tighter the bid to offer spread on the underlying equity, the tighter the spread on the convertible. The age of an issue. More recent issues usually see the greatest volume of transactions, whereas older issues are often stored away by long term investors and traded less frequently. Ownership Restrictions: ‘Seasoning’ Local laws may affect the ability of investors to either own or convert Euroconvertibles, or may restrict these privileges to certain types of investor. Typically, these restrictions apply more to the initial offering rather than secondary market transactions. ‘Seasoning’ for purposes of compliance with the US Securities Act of l933 (‘Act’) and in particular with the ‘safe harbor’ provisions of Regulation S of the Securities and Exchange Commission (SEC) refers to the passage of a period of time following the initial public distribution outside the US of an issue of securities, during which sales of the securities into the US or to US persons are restricted. Once the restricted period has passed, the offering is deemed to ‘come to rest’ and thereafter may be sold as a secondary offering into the US and to US persons, without the need to register the securities under the Act so long as the

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offering is not characterized by extraordinary selling efforts or otherwise constitutes a new public distribution in the US market. However, individual state ‘blue sky’ laws might restrict the universe of eligible investors.

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9.

Convertible Market Profiles Introduction to Market Profiles Further Information France Germany Hong Kong India Italy Japan Korea Philippines Switzerland Taiwan Thailand UK US Rest of Asia Rest of Europe Africa and Eastern Europe

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Introduction The diversity of structures, issuers, markets and regulatory environments comprising the global convertible market make it impossible to create a fully comprehensive set of market profiles. In the following pages, however, we have attempted to offer at least a flavor of the market. For each major market we have included summary information on the following subjects:

1.

Convertible market capitalization broken out by sector.

2.

Recent volumes of new issuance (1995-97 Q1).

3.

Coupon levels.

4.

Time to maturity of outstanding instruments as of end February 1997.

5.

Premium levels as of end February 1997.

6.

Yield to maturity levels as of end February 1997.

7.

The currencies in which convertibles are denominated.

8.

The significance of the domestic convertible market versus the Euroconvertible market.

9.

Liquidity.

10. Settlement procedures. 11. The convertible instruments most widely issued. 12. The composition of the investor base. 13. Quotation methods. 14. Ease (or otherwise) of conversion. 15. The largest outstanding instruments. Further Information Calculation of market capitalization (and new issue volumes) for the convertible market is complicated by the existence of private placements, very small issues, and convoluted definitions. We have confined ourselves in the following pages to publicly traded issues with an issue size (by proceeds) over US$25 million. The four market structure charts included for each market (coupon, time to maturity,

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premium, yield to maturity) give a snapshot of the extant market at the end of February 1997. Each bar represents one issue. For many of the markets, we have only included information on the very largest outstanding instruments: in Japan, for example, we have only included 300 instruments out of a universe of over 1,000. For ease of comparison, summary market capitalization and issuance data is all included in US$. The sectoral breakdown of the convertible universe is also included using a series of generic sector definitions. Fully comprehensive (and up-to-date) market profiles are available on request from Goldman Sachs Global Convertible Securities Research Group.

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10. Glossary of Convertible Terms Absolute call The right of the issuer to redeem the bond at any time, under any circumstance (ie, without precondition). Accrued interest The interest earned since the last coupon payment. ACES (Automatically Convertible Equity Securities) A type of convertible security which is mandatorily convertible into common stock at maturity. Also known as DECS and PRIDES. Anti-dilution clause An investor protection measure which provides for the adjustment of the conversion ratio in the event of stock dividends or stock splits. At the money convertible See balanced convertible. Balanced convertible A convertible which offers some (at least 25%) upside participation with the underlying shares and only a part (no more than 75%) of the downside of the underlying shares. Bond premium The difference between the market price of the convertible and its bond value. Bond with warrant (Bond cum warrant) Instruments created by combining a straight bond with an option or a warrant. Analytically, a bond with warrant package offers similar but not identical features to a convertible bond. Bond value The value of the ‘straight’ fixed income element of the convertible alone, without regard to the value of the convertible's equity option.

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Breakeven The number of years it takes for an investor to recover the conversion premium from the convertible's higher income relative to an investment of an equivalent cash amount in stock. Purchase price of convertible

Market value of underlying shares

Breakeven = Annual income from convertible

Annual income from equivalent amount of stock

(Convertible price - Parity) = (Bond coupon - (Stock dividend yield *Convertible price)) Busted convertible A convertible bond whose conversion price is so far above the actual stock price that it trades close to its bond value. Call feature The right of the issuer to redeem the convertible prior to maturity at a stated price. Clean (or net) price Convertible bond price quoted exclusive of accrued interest. Most convertible bonds are quoted clean. Conversion premium The difference between the market value of the convertible and its parity value, usually expressed as a percentage of parity value. Conversion price The price per share at which the convertible can be converted into common stock. Conversion ratio The number of shares of common stock into which each bond can be converted.

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Conversion value See parity value. Convertible bonds Debt securities issued by a company that are convertible at the investor's option into common stock of that company. Convertible debentures See convertible bonds. Convertible preferreds Preferred shares issued by a company that are convertible at the investor's option into common stock of that company. Convertible QUIPS A type of convertible security which is similar to convertible preferred for the investor but offers the issuer tax and rating advantages. Current yield The yield that the investor receives based on the current price of the convertible. Calculated as coupon divided by current convertible price Denomination The minimum size in which a convertible may be traded. Dirty (or gross) price Convertible bond price quoted inclusive of accrued interest. Some Euroconvertibles (especially in France) which have domestically traded tranches may be quoted on this basis. Discounted income advantage The present value of the difference between the convertible's coupon and the underlying stock's dividend. The dividend is assumed to grow annually. The difference between coupon and dividend payments is discounted over the period until the dividend exceeds the coupon for the first time.

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Exchangeable A convertible issued by a company that can be converted into another company's shares rather than its own. In the US, exchangeable can have another meaning, namely the right of an issuer, if so stated, to exchange its existing convertible preferred for convertible debentures with identical terms. Fixed exchange rate The exchange rate on a cross-currency bond at which the redemption value (typically in US$) is calculated at maturity. These features are most prevalent in Thailand. Flexible put convertible A rolling put convertible in which the issuer establishes the price and date of just the first put option at the convertible's original issue date. The terms of each succeeding put are established just prior to the preceding put, in order to give the issuer maximum flexibility to reflect changes in market conditions between put dates. Gamma The sensitivity of the delta of a convertible to changes in the stock price is referred to as the gamma. It is the ratio of the change in the convertible’s delta to the (small) corresponding percentage change in the stock price that produced it. Hard call protection A period during which a convertible is not callable for early redemption by the issuer under any circumstances (except in cases of force majeure). In the money Stock price is above the conversion price. Investment value See bond value. Junk convertible A convertible of a low credit quality company, typically trading on a very high yield to maturity.

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Mandatory convertible A convertible bond which the holder is obliged to convert into equity at maturity. Out of the money Stock price is well below the conversion price. The embedded warrant has no intrinsic value. Original issue discount A convertible bond which is issued at a discount to par value and pays a nominal or no coupon. The value of the bond appreciates to par through the life of the convertible at a rate equal to the yield to maturity. Par The face value of the convertible. For non premium put convertibles this is also the redemption value at final maturity. Par put convertible A convertible in which the investor has a put option prior to final maturity, and the strike price of the put is at par. Parity value The market value of the shares of common stock into which the convertible can be converted. Calculated by multiplying the stock price by the conversion ratio. Payback See breakeven. Points premium The market price of a convertible minus its parity value. Preferred Equity Redemption Cumulative Stock (PERCS) See Yield Enhanced Stock (YES). Premium put convertible A convertible in which the investor has a put option prior to final maturity, and the strike price of the put is at a premium to par.

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Premium redemption convertible A type of discount convertible where the security is issued at par but redeems above par. Provisional (or soft) call A feature that allows a convertible to be called for early redemption by the issuer but only if the issuer's share price is above a predetermined premium to the conversion price. Put An option, exercisable by the investor, to redeem the convertible prior to final maturity for a given amount. Rho The sensitivity of the convertible to changes in interest rates is referred to as rho. It is the ratio of the change in the convertible price to the (small) change in interest rates that produced it. Risk premium The market price of a convertible minus its investment value, expressed as a percentage of par. Rolling premium put convertible A premium put convertible with several premium put options. Typically, each put is structured in such a way that on any put date, the terms of the next put are sufficiently attractive that the investor has an economic incentive to continue holding the convertible until the next put date, rather than exercise the put. In this way the convertible should remain outstanding until final maturity or until it is converted. Theta The sensitivity of the convertible to changes in time to expiration is referred to as theta. It is the ratio of the change in the convertible price to the (small) change in the time to expiration that produced it. Useable bond with warrant Variation on traditional bond with warrant, where the bond element can be used to exercise the warrant as an alternative to cash. In practice, this combination behaves like a vanilla convertible.

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Vega The sensitivity of the option price to changes in volatility is referred to as vega. It is the ratio of the change in the convertible’s price to the (small) corresponding percentage change in the stock’s volatility that produced it. Yield advantage Difference between the current yield on the convertible and the stock dividend yield. Yield Enhanced Stock (YES) A type of mandatory convertible. This security is characterized by a zero issue premium, high yield advantage over the common stock and a predetermined cap on capital appreciation. Yield pickup See yield advantage. Zero coupon convertible A convertible without an annual coupon which is issued at a deep discount to, and matures at, par. Typically, this structure will also have several put options in years prior to maturity.

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11. Figures in Text Figure 1:

Securities Market Capitalization Comparisons (US$)

5

Figure 2:

The Equity-linked Financing Spectrum

5

Figure 3:

The Equity Perspective on Convertibles

7

Figure 4:

The Fixed Income Perspective on Convertibles

7

Figure 5:

Basic Convertible Price Behavior

8

Figure 6:

Calculating Parity

9

Figure 7:

Market Terminology

10

Figure 8:

Introducing Premium

11

Figure 9:

Calculating Premium over Parity

12

Figure 10:

Calculating Risk Premium

13

Figure 11:

Calculating Breakeven

15

Figure 12:

Cookson 7% 2004 - Anatomy of a Balanced Convertible

20

Figure 13:

Michelin 2.5% 2001 - Anatomy of an In the Money Callable Convertible

21

Daimler 4.125% 2003 - Anatomy of an In the Money Non Callable Convertible

22

Figure 14:

Figure 15: KEPCO 5% 2001 - Anatomy of an Out of the Money Convertible

23

Figure 16:

Junk Convertibles – The Investment Floor ‘Disappears’

24

Figure 17:

Anatomy of a Junk Convertible - NTS Steel 4.0% 2008

25

Figure 18:

ACES Terms at Issuance

32

Figure 19:

Dole Food ACES Payoff Profile at Maturity

33

Figure 20:

Total Return Analysis for Dole Food ACES if Held to Maturity

34

Figure 21:

Valuing ACES

35

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208

Figure 22:

Breaking Down a Convertible Quips

38

Figure 23:

Convertible QUIPS Terms at Issuance

38

Figure 24:

Simplified Annual Cost to Issuer of Normal Convertible

40

Figure 25:

Simplified Annual Cost to Issuer of CrEDITS

41

Figure 26:

(Bankgesellschaft Berlin) Metro Exchangeable Terms and Valuation at Issue

42

Figure 27:

Summary Issue Terms for the (Italian Government) INA PENs

44

Figure 28:

Issue Terms for Marriott International, Inc. 0% 2011

45

Figure 29:

Pay Off Profile at Maturity for a Mandatory Convertible with Reset Feature

48

Figure 30:

Negative Gamma Illustrated

49

Figure 31:

YES Terms at Issuance

52

Figure 32:

SunAmerica PERCS Payoff Profile at Maturity

53

Figure 33:

Valuing YES

54

Figure 34:

Total Return Analysis for SunAmerica PERCS if Held to Maturity

55

Figure 35:

Convertible Valuation Influences

59

Figure 36:

Illustration of Convertible Asymmetry

61

Figure 37:

Nedlloyd Group 4.5% 2001

63

Figure 38:

Quintiles Transnational 4.25% 2000 Premium (%)

64

Figure 39:

Royal Sun Alliance 7.25% 2008

65

Figure 40:

Ashanti 5.5% 2003

66

Figure 41:

VLSI 8.25% 2005

66

Figure 42:

Bangkok Bank 1.5% 2006

67

Figure 43:

Aegon 4.75% 2004

68

Figure 44:

Banamex 7% 1999

69


Figure 45:

Anatomy of a Convertible Strip (Part 1)

73

Figure 46:

Anatomy of a Convertible Strip (Part 2)

73

Figure 47:

Anatomy of a Convertible Strip (Summary)

74

Figure 48:

Convertible Stripping in the ‘Real World’

75

Figure 49:

Growth of $1 Invested at Year-End 1956 in Convertibles

79

Figure 50:

Growth of $1 Invested at Year-End 1973

80

Figure 51:

Summary Statistics Since 1956

80

Figure 52:

Summary Statistics Since 1972

81

Figure 53:

Risk and Return - 5 Year Increments 1957-1995

81

Figure 54:

Risk and Return - 5 Year Increments 1957-1995

82

Figure 55:

Convertible, Long-term and Intermediate-term Bonds: Calculation of Jensen’s Alpha and Beta 1973-1995

82

Convertible Bonds and S&P 500 Yearly Total Returns 1973-1995

83

Analysis of Monthly Total Returns in Up and Down Markets 1973-1995

84

Correlation of Convertible Bonds with Other Major US Asset Classes

85

Estimates of the Long-Run Expected Return and Standard Deviation for Convertible Bonds and Major US Asset Classes

86

Correlation Matrix for Convertible Bonds and Major Asset Classes

87

Figure 61:

Relative Cost of Capital of Differing Financing Alternatives

93

Figure 62:

A Broader Cost of Capital Comparison

94

Figure 63:

Issuer Checklist for ACES*

98

Figure 64:

Issuer Checklist for YES

98

Figure 65:

Issuer Checklist for Convertible Preferreds

99

Figure 56: Figure 57: Figure 58: Figure 59: Figure 60:

209


210

Figure 66:

Issuer Checklist for Vanilla Convertible Debt

99

Figure 67:

Issuer Checklist for Discount Convertible Debt

100

Figure 68:

Issuer Checklist for Zero Coupon Convertible Debt

100

Figure 69:

New Issue Summary Information

101

Figure 70:

One-period Stock Tree

105

Figure 71:

One-period Convertible Tree

105

Figure 72:

Hypothetical Terms

110

Figure 73:

Letter Codes

110

Figure 74:

Binomial Trees for Valuing the Convertible Bond

111


12. Select Bibliography Altman, EL ‘The Convertible Bond Market: Are Returns Worth the Risk?’ Financial Analysts Journal, July-August 1989. Black F, and M Scholes ‘The Pricing of Options and Corporate Liabilities’ Journal of Political Economy 81, 1973. Brennan, MJ, and ES Schwartz ‘The Case for Convertibles’ Continental Bank Journal of Applied Corporate Finance, Summer 1988. Brennan, MJ, and ES Schwartz ‘Convertible Bonds: Valuation and Optimal Strategies for Calls and Conversion’ Journal of Finance, December 1977. Ingersoll, JE, Jr. ‘A Contingent-Claims Valuation of Convertible Securities’ Journal of Fixed Income, September 1993. Lummer, SL, and MW Reipe ‘Convertible Bonds as an Asset Class: 1957 - 1992’ The Journal of Fixed Income Vol 3 No.2 September 1993. McGuire, SR The Handbook of Convertibles New York: Simon & Schuster, 1991. Mikkelson, WH ‘Convertible Calls and Security Returns’ Journal of Financial Economics 9, 1981.

211


13. Appendices Appendix 1: Convertible Bond Total Returns (%) 1957-95 Appendix 2: Convertible Market Acronyms

213


Appendix 1: US Convertible Bond Total Returns (%) 1957-95 Year 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 Source: Ibbotson Associates

214

Total Return -12.57 28.40 3.75 -1.17 17.44 -10.53 7.03 10.18 22.79 -9.53 19.42 10.12 -26.11 -0.62 21.60 2.88 -8.20 -10.85 26.10 27.98 4.87 5.43 16.98 26.12 3.69 31.02 11.25 3.75 28.01 17.25 -2.96 13.42 12.47 -3.70 26.86 11.15 15.45 -1.90 22.36


Appendix 2: Convertible Market Acronyms Acronym

Bank

ACES

Goldman Sachs

CHIPS

Bear Stearns

CrEDITS DECS ELITES

Full Name Automatically Convertible Equity Securities Common-Linked Higher Income Participation Securities

Goldman Sachs

Credit Enhanced Debt Indexed to Stock

Salomon Brothers

Dividend Enhanced Convertible Stock

BZW

Equity Linked Income Tilted Euro Securities

Convertible MIPS

Goldman Sachs

Convertible Monthly Income Preferred Securities

Convertible QUIPS

Goldman Sachs

Convertible Quarterly Income Preferred Securities

Convertible TOPrS

Merrill Lynch

Convertible Trust Originated Preferred Securities

LYONS

Merrill Lynch

Liquid Yield Option Notes

NEWS

Goldman Sachs

Notes with Equity Warrant Securities

OSCARs

Goldman Sachs

Obligations Subordonnées Convertibles en Actions ou Remboursables

PENs

Goldman Sachs

Privatization Exchangeable Notes

PEPS

Morgan Stanley

Premium Exchangeable Participating Shares

PERCS

Morgan Stanley

Preferred Equity Redemption Cumulative Stock

PERQS

Morgan Stanley

Preferred Equity Redeemable Quarterly-Paid Shares

PRIDES

Merrill Lynch

Provisionally Redeemable Income Debt Exchangeable for Stock

TOPrS

Merrill Lynch

Trust Originated Preferred Shares

SAILS

CS First Boston

STRYPES

Merrill Lynch

TECONS

JP Morgan

YES

Goldman Sachs

Stock Appreciation Income Linked Securities Structured Yield Product Exchangeable for Stock Term Convertible Securities Yield Enhanced Stock

215


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