Convexity ratio o Classic"two-thirds upside, one-third downside o Convexity ratio is the ratio of upside and downside participation For example, suppose the convertible provides 64% of the upside participation with only 34% of the downside movement then the convexity ratio is 1. 85. That is, the convertible provides 85%o more upside participation than downside risk Convertible bonds
Slide: 6 Classic “two-thirds upside, one-third downside” Convexity ratio is the ratio of upside and downside participation. For example, suppose the convertible provides 64% of the upside participation with only 34% of the downside movement, then the convexity ratio is 1.85. That is, the convertible provides 85% more upside participation than downside risk. Convertible bonds
Insulation from volatility The price movements of convertibles are generally far less volatile Convertible Bond Price Changes August 24, 2001-September 21, 2001 Common Stock Convertible Closing Price Closing Price % Closing Price Closing Pi C 24820012192001 Change24820021200che Avon Products 44.04 4.03 51.13 51.25 0.24 Bell atlantic/ 17.85 14.15 20.73 100.50 101.25 0.75 New Zealand Tel Diamond Offshore 2790 2635 84.13 0.75 Federal Realty Trust 23.62 -13.97 93.2 87.13 -6.57 INCO 1755 12.45 -2906 9938 97.25 2.14 Average -14.15 2.78 DJIA 10423.208235.81 -20.99 20.99 S&P500 1184.90 96580 18.49 -18.49 NASDAQ 1916.80 1423.19 25.75 -25.75 Convertible bonds
Slide: 7 The price movements of convertibles are generally far less volatile. Closing Price Closing Price % Closing Price Closing Price % Company 24/8/2001 21/9/2001 Change 24/8/2001 21/9/2001 Change Avon Products 45.89 44.04 4.03 51.13 51.25 0.24 Bell Atlandtic/ New Zealand Tel 17.85 14.15 -20.73 100.50 101.25 0.75 Diamond Offshare 27.90 26.35 -5.56 83.50 84.13 0.75 Federal Realty Trust 23.62 20.32 -13.97 93.25 87.13 -6.57 INCO 17.55 12.45 -29.06 99.38 97.25 -2.14 Average -14.15 -2.78 DJIA 10423.20 8235.81 -20.99 -20.99 S& P 500 1184.90 965.80 -18.49 -18.49 NASDAQ 1916.80 1423.19 -25.75 -25.75 Common Stock Convertible Convertible Bond Price Changes, August 24, 2001-September 21, 2001 Convertible bonds
Call features Convertible bonds
Slide: 8 Call features Convertible bonds
Call terms o Issuer has the right to call back the bond at a pre specified call price prior to final maturity, usually with a notice period requirement. Upon call, the holder can either convert the bond or redeem at the call price Convertible bonds
Slide: 9 Issuer has the right to call back the bond at a prespecified call price prior to final maturity, usually with a notice period requirement. Upon call, the holder can either convert the bond or redeem at the call price. Convertible bonds
Issuer's perspective on the call right o To have the flexibility to call if they think they can refinance the debt more cheaply o To force bondholders to convert debt into equity which can reduce debt levels and result a beneficial effect on the balance sheet. The issuer has the flexibility to shift debt into equity to reduce the leverage of the firm. In summary, it is used as a tool by issuer for possible future equity financing managing the debt /equity balance Convertible bonds
Slide: 10 To have the flexibility to call if they think they can refinance the debt more cheaply. To force bondholders to convert debt into equity, which can reduce debt levels and result a beneficial effect on the balance sheet. The issuer has the flexibility to shift debt into equity to reduce the leverage of the firm. In summary, it is used as a tool by issuer for possible future equity financing – managing the debt / equity balance. Convertible bonds