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Strategies & Market Trends : John Pitera's Market Laboratory -- Ignore unavailable to you. Want to Upgrade?

To: OX who wrote (5094)	11/16/2001 12:51:45 PM
From: John Pitera	Read Replies (2) \| Respond to of 33421

Hi OX, I believe that most conversion methods for convertible bonds enable you to convert them at any time into the common stock of the underlying company. But it's an excellent question. Morgan Stanley's Convertiblebonds.com site has a glossary and they talk about theoretical hedge ratio, where you are long the convert and short the stock. You could have the same problem with being short the common stock as you would have being short calls on the stock. If the stock goes from 100 to 500 in a few months like we saw in late 1999, and you could not convert the bond to common stock at will, then you'd be short a stock that could be called away, and the stocks like AMZN, the old iridium, and other were very hard to borrow since so many were short them. there are call date provisions on many converts where they can be called in by the company, after certain intervals. If the company is doing very well and the share price is rising nicely with future advances likely, it's less dilutive to use some corporate cash flow to retire the convertible bond. check this out ------------------ Theoretical Hedge Ratio: A statistical value determined by an evaluation model. It can have several interpretations. The Hedge Ratio typically gives investors an idea of how sensitive the convertible will be relative to movements in the common stock. A Hedge Ratio of 90%, for example, will indicate that the convertible is very sensitive to its underlying equity moves, while a Hedge Ratio of 20% would suggest the convertible is relatively insensitive to movements in its underlying stock. The Hedge Ratio is also used to determine the number of shares to sell short when executing an Arbitrage strategy. The Hedge Ratio is multiplied by the conversion ratio to determine the number of shares to sell short. Theoretical Value: A statistical value for a convertible security based on a risk neutral model, such as Black Scholes or Cox-Ross. This model takes into account the terms of the convertible, including its coupon, maturity, conversion ratio, call protection and credit spread. Also taken into account are the underlying stock’s volatility and stock dividends. A yield curve, or a single yield is also typically used in the evaluation. The model arrives at a single value for each security. This can be compared to the security’s trading price to arrive at an over/under valuation. By buying undervalued convertible bonds, a portfolio could achieve out performance versus the convertible market in general. The ConvertBond.com model uses a 410 period Cox-Ross model to calculate the Theoretical Value for the convertible securities under its evaluation. ------------------ Brief Review of Convertible Security Types I. Convertible Bond. A convertible bond provides the performance attributes of common stock and a bond. These securities typically pay a semi-annual coupon of 4.00% to 5.00%. The security is typically a subordinated debenture with a fixed principal amount and time to maturity with a right to convert into common stock based on its conversion ratio. The upside of the convertible comes from its common stock component, while the downside protection comes from the cash coupon, fixed maturity, and status in the capital structure which is senior to common and preferred stock. II. Convertible Preferred. A convertible preferred also has features similar to a convertible bond. However, convertible preferred stock is subordinated to debt of the issuing company. It typically offers a coupon of 6.00% to 7.00%. A convertible preferred typically pays a cash coupon on a quarterly basis, and is also perpetual or with a long maturity. Valuation: For equity oriented investors, convertibles can be viewed as either a Stock plus Put, or Bond plus Call. A. Stock plus Put. A convertible security can be viewed as a stock plus a put. The upside of the convertible comes from the underlying stock. The higher the price of the underlying stock goes, the higher the convertible price should go. The downside protection of the convertible comes from its higher yield, fixed maturity value, and status in the capital structure, which all combine to give the security downside protection. B. Stock Alternative. At very high prices, the convertible still should provide a higher current yield than its underlying common stock and have a low premium. The combination of the higher yield and low premium results in a low breakeven time. The breakeven time is the time it would take a buyer of a convertible to recover the premium paid for it. Low breakeven convertibles typically have the most equity sensitivity, and given the yield advantage, it is not unusual for a convertible with this characteristic to outperform the common on a total return basis. C. Bond plus Call. A convertible can also be viewed as a bond plus a call. In this case the upside of the convertible comes from the call represented by the conversion feature. Moreover, the downside protection also comes from the bond attributes of the security, including the generally higher yield, fixed maturity value, and place in the capital structure. III. Mandatory Convertibles (PEPS). PEPS, or Participating Equity Preferred Shares, are a type of convertible security that is designed to provide investors with high current income along with high equity-like participation in the underlying stock. PEPS usually provide a coupon of 6.00% to 8.00% and are issued with relatively low premiums of 18% to 23%. The PEPS coupon is usually paid quarterly. These securities typically mature in 3 to 5 years, are typically listed, and are usually call protected for most of their life. IV. PHONES, ZONES and ZENS. These securities are usually issued at the same price as the common with an exchange premium of 5.26%. They typically have a yield that is 1.50% to 2.00% greater than the common dividend, and in most cases this coupon is subject to any additional common stock dividend distribution. PHONES typically have maturities of 30 years. These securities can be exchanged at any time into a cash value equal to 95% of an average price of the underlying common stock over a period of trading days. For taxable investors, these securities do have a negative phantom tax implication. These securities are typically callable at any time at a call price equal to the higher of the issue price or the market value of the underlying common stock, plus a coupon make whole that gives holders any unpaid coupons for the first three years of the security’s term. convertbond.com