Educational Programming Video
The Value Line Convertibles Survey
Program 2: Explanation of the structure of a convertible security
and definitions of some terminology.
In our last session, we provided a brief definition of a convertible security and discussed The Value Line Convertibles Survey. In this session, we will define some of the terminology used within this specialized area, and provide a closer look at the structure of a convertible.
These are some of the more frequently used terms. The first is Conversion price …this is the price per share at which common stock will be exchanged for a convertible security. This price is set at the time of issuance of the convertible security and is almost always at a premium to the prevailing common stock price. The conversion price is usually adjusted for events within the company, such as stock splits, mergers or spin-offs. The principal amount of a convertible security divided by its conversion price equals the number of shares (or Conversion Ratio) that will be received upon conversion.
Next is Conversion ratio:…This is the number of shares the convertible security is exchangeable for at conversion. It is derived by dividing the par value of the bond or the liquidation value of the preferred stock by the conversion price.
Conversion value:…This is the $value of the common shares received upon conversion. This value is easily calculated by multiplying the conversion ratio x the stock price. Example: if the conversion ratio is 5.125 and the stock is $25, the conversion value would be $128.13.
Premium over conversion value: This is the percentage by which the current price of the convertible exceeds the current conversion value. Example: If the price of the bond is 130 and the conversion value is 100, the premium over conversion value is 30%.
Investment value:…This is the implied value of the security without the conversion feature. In other words, the price the security would likely command were it a straight bond, given the same coupon, maturity and investment quality.
Premium over investment value:…This is the percentage by which the price of the convertible exceeds its investment value. Example: if the price is 130 and the investment value 65, the premium over investment value is 100%.
Coupon/Dividend: The annual rate of interest or dividend payable on a bond or preferred share. Bonds are almost always issued with a par value of $1,000, the price at which they are redeemed at maturity. So, a bond with a 6.75% coupon pays $67.50 a year for the duration of the bond.
Call price: This is the price at which the convertible security may be called, if it is callable.
Call protection: Almost all convertibles are issued with some degree of call protection, which is a certain period of time during which the issuer of the convertible security cannot recall the convertible. This time period is at the initial stage of the life of the security and is generally 2 years to 5 years. However, there are typically two kinds of call protection.
"Hard call" protection, which means that the issue cannot be called for any reason during this specific period, and "Provisional Call" protection (sometimes referred to as "soft call" protection) which enables the company to exercise the right to call the security if certain pre-set conditions are met. Sometimes, a security will have both kinds of call protection. A convertible that has provisional call protection may be called only if the underlying stock rises to a stated price and remains at that price or higher for a certain number of days, usually 20 of 30 consecutive trading days.
These are some of the terms that you will hear when dealing with convertibles and it behooves convertible investors to get familiar with them; other terms, which will come up during our sessions, will be defined as we go along.
Now let's discuss the structure of a convertible. A traditional convertible security is a hybrid investment instrument with two key components: A fixed income portion (the part that is like a straight bond) and a warrant (or option) on the stock underlying the convertible (the conversion feature). Both the bond market and the stock market directly affect a convertible's value. A convertible's value is drawn both from the value of its income (the bond portion) and from its conversion privilege (the value of the warrant portion, which depends on the value of the underlying stock. Since convertible bonds and convertible preferred stocks can be exchanged for underlying common stocks, over time as the underlying stock moves up or down, a convertible issue can take on the features of an equity, a fixed debt instrument, or a combination of both. The bond (or investment) value of a convertible provides a "floor value" below which the issue should not trade. In addition, the conversion value also forms a level below which the convertible should not trade, if the conversion value is above the bond value. Most often, however, convertibles sell at premiums above both their conversion values and estimated investment values. If you buy a convertible at its investment value, you get the conversion feature free of cost. In the same way, if you purchase a convertible at its conversion value, you receive the bond feature free of cost.
I hope you now have a deeper understanding about the structure of a convertible security. In our next session, we will discuss why companies choose to issue convertible debt instead of regular bonds or borrowing from financial institutions. Also, we will discuss the safety feature of a convertible security versus common stock and why you may want to buy convertibles instead of common stocks.