CONVERTIBLE BONDS AND WARRANTS

A convertible bond is usually a debenture that can be converted into a stated number of
shares of common stock of the company that issued the bond. The conversion price is
generally above the common stock price prevailing at the time of issue. Because convertibles
are considered attractive due to the conversion feature, interest rate on them is below the
firm’s straight debentures. .

Features: Most convertibles are subordinated debentures. Virtually all convertibles are: (1)
callable, (2) have anti-dilution clauses against stock splits, stock dividends, and firms issuing
equity at lower than conversion price. Some convertibles have stepped-up conversion prices
with the length of time outstanding. If the stock price does not rise sufficiently to induce
conversion, the issue is said to be an “overhanging issue”.

Advantages to Issuing Firms: (1) Interest cost is lower than straight debt, and the interest
savings depend on the growth prospects of the firm. (2) Allow firms to sell common stock at
higher prices than currently prevailing (because of depressed conditions), thus reduce dilution
in EPS.

Disadvantages: If the stock price rises substantially, the firm would have been better off
issuing straight debt and refunding it later with issue of common stock at higher prices. On
the other hand, if the price does not rise substantially to convert, the company may be stuck
with an overhanging debt issue - preventing the firm to expand its equity base.

Advantages to Investors: (1) Convertibles provide upside potential of a common stock and
downside protection of a bond. As the stock price increases, the price of the convertible
increases at least to the conversion value. Irrespective of what happens to the stock, the price
of the convertible will never decline below what it would be worth as a straight bond. (2)
Convertibles provide higher current yield than underlying stock.

Illustrative Problem: An 8% coupon debenture, with 20 years remaining to maturity, is

convertible at any time into common stock at $50 (conversion price). The convertible is
currently selling at $900. The stock into which it is convertible currently is selling at $42
and pays an annual dividend of $1 per share. Assume that the yield on similar but non-
convertible bonds is 10.5%. Required: Evaluate the convertible from an investor’s
perspective.

Analytical Procedures

(1) Evaluate the issue as if it were a straight debenture.

• Make sure the quality of the bond is satisfactory, look at bond rating.
• Determine if the time is right for buying fixed income securities (i.e., interest rates
are not expected to rise substantially).
• Determine the straight bond value of the issue without the conversion feature.
• Determine the investment premium = Price of convertible - straight bond value.
• Determine whether you are willing to accept the down side risk.

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(2) Determine how much the investor stands to gain from the conversion privilege,
stock value.
• Find the conversion premium = price of convertibility- conversion value (smaller
the conversion premium, more desirable the convertible).
• Calculate the conversion parity price (CPP) = price of convertible/conversion
ratio.
• Analyze the potential price of common stock.
• Analyze the period of time it takes to recover the conversion premium from
higher interest yield on convertible compared to dividend income from common
stock.

WARRANTS

Warrants can be viewed as call options issued by corporations on their own stocks, usually
for a much longer time period than options. They are usually issued by firms in conjunction
with bonds or preferred stocks as “sweeteners”. The security to which a warrant is attached
is called the host security. Warrants may be detached from the host security and separately
traded on either an exchange or in the OTC market.

More recently, warrants have been issued on stock indexes called index warrants. As with
stock index option, the buyer of an index warrant can purchase the underlying stock index.
These warrants are issued either by a corporate or sovereign entity as part of security
offering. They are guaranteed by an option clearing corporation.

Reasons of Issuing Warrants: (1) Lower the Cost of the Host Issue: Since warrants offer
promise of sharing in the firm’s future growth (option), investors are willing to accept lower
coupon rate on the host security. (2) Increase Future Equity: Like convertibles, warrants
allow the firm to issue equity in the future at a higher price. (3) Offset Relatively High Risk
of the host.

Security: When there is considerable risk on a debt security, firm may not be able to borrow
without the promise of some equity participation if the firm is extremely successful. Warrant
serves as an equity “kicker” to make a bond issue more attractive.

Value of Warrants: Warrants have an intrinsic and time value related to the volatility ot’ the
underlying stock and other factors affecting the option.

Intrinsic Value of a Warrant = ( S − X ) × n

where: S = market price of common stock

X = excise price of the option
n = number of shares per warrant

Example: A firm issues a $1,000 par bond with five warrants attached, each warrant allows
the holder to purchase four shares of common stock before expiry of the options at the
exercise price of $20. The common stock is presently selling at $40.

The actual price of the warrant before expiry typically exceeds the intrinsic value because of
the time value and other speculative factors. Similarly, when the exercise price exceeds the

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market price of the common stock, the warrant price may be positive because of future
expectations.

Terms: Most warrants have expiration dates many years into the future, and some are
perpetual issues. Exercise prices are usually set well above the prevailing price of the stock at
the time the warrant is issued (in contrast with short-tern rights offerings, where the
subscription price is below the market price). Some times stepped-up- exercise prices are
used to encourage early exercise. Anti-dilution clauses to protect investors against stock splits
and stock dividends arc usually included.

Effect of Warrants on Capital Structure: When investors exercise warrants at the contract
price, the result is sale of additional common stock by the corporation and an increase in its
equity capital. Thus, the effect of warrants and convertibles is different on firm’s capital
structure. When a firm issues convertibles and forces conversion, debt is replaced with
equity. When warrants attached to bonds are exercised, bonds are not retired instead warrant
holders pay exercise price to the firm for the common stock. The exercise of warrants
increase equity funds without reduction in firm’s outstanding debt.

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