HIGH Grade Convertible Bonds

1. HIGH Grade Convertible Bonds By T.J. Kaleikini

2. What is a Bond? • a certificate of debt (usually interest-bearing or discounted) that is issued by a government or corporation in order to raise money; the issuer is required to pay a fixed sum annually until maturity and then a fixed sum to repay the principal

3. Definition • Infinance, a convertible bond (or convertible debenture) is a type of bond that can be converted into shares of stock in the issuing company, usually at some pre-announced ratio • A bond that can be converted into a predetermined amount of the company's equity at certain times during its life, usually at the discretion of the bondholder.

4. How it Works… • The exchange feature of a convertible bond gives the right for the holder to convert the par amount of the bond for common shares a specified price or "conversion ratio". For example, a conversion ratio might give the holder the right to convert $100 par amount of the convertible bonds of Ensolvint Corporation into its common shares at $25 per share. This conversion ratio would be said to be " 4:1" or "four to one".

5. How it works cont • Investors buy convertible bonds to gain a higher current yield and less downside, since the convertible should trade to it bond value in the case of a steep drop in the common share price.

6. Examples • Example Let’s say that TSJ Sports issues $10 million in three-year convertible bonds with a 5% yield and a 25% premium. This means that TSJ will have to pay $500,000 in interest annually, or a total $1.5 million over the life of the converts. If TSJ’s stock was trading at $40 at the time of the convertible bonds issue, investors would have the option of converting those bonds for shares at a price of $50 ($40 x 1.25 = $50). Therefore if the stock was trading at say $55 by the bond's expiration date, that $5 difference per share is profit for the investor. However there is usually a cap on the amount the stock can appreciate through the issuer’s callable provision. For instance, TSJ executives won’t allow the share price to surge to $100 without calling the converts (recall the paragraph on forced conversion). Alternatively, if the stock price tanks to $25 the convert holders would still be paid the face value of the $1,000 bond at maturity. This means that convertible bonds limit risk should the stock price plummet, while limiting exposure to upside price movements of the underlying common stock.

7. How Risky • Not very risky because…. By investing in converts you are limiting your downside risk at the expense of limiting your upside potential.

8. Risks!! • Bonds, whether convertible or not, are only as good as the strength of the company behind it. In the past year or so, the credit quality of convertible bonds has dropped off.  • Indeed, half of the convertible market comprises issues in technology and telecommunications, both of which can be volatile sectors.  • Convertible funds also tend to be more expensive than domestic stock funds because most carry loads, or sales charges.  • And just because a fund invests in convertible securities doesn't mean it will always be less risky than a regular stock fund. 

9. Lose-Lose Situation • Probably the most frustrating aspect of a convertible is its call feature - often overlooked in its evaluation. If interest rates should decline significantly after the convertible bond is issued, most companies can and will call their bonds, in which case one loses the source of what had been a relatively attractive income, and must then reinvest the proceeds in another vehicle at the then lower rates of interest. On the other hand, if interest rates go up, there is no chance that the bond will be called, and so the investor is stuck with a lower-than-market rate of interest on the bonds. This is an example of a "heads, you lose; tails, you don't win" type of investment

10. Who uses it? • PEOPLE WHO ARE: Sleepless because of market volatility? You may want to consider convertible securities.  • investors in General