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Structures

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Editors note: This is the sixth of a six-part series. Click here to read part one, here for part two, here for part three, here for part four and here for part five.

The most profitable area on Wall Street for the past ten years has been the creation of "structured products," hybrid securities that are part cash instrument (like a bond) and part derivative (like an option). Companies have used these products, primarily through the issuance of hybrid equity and fixed income securities, more than any other form over the recent past to raise funds in the primary market because they afford a much greater degree of flexibility. Credit worthy companies can cheapen the cost of capital by "selling" away the volatility of their stock ,while non-credit worthy companies can access the capital markets like never before.

These securities take many forms but they all basically involve a cash instrument plus embedded derivatives to tailor the security to fit the needs of the issuer. One of the oldest and easiest structured products is the convertible bond.

A convertible bond is a debt instrument that can be converted into shares of the issuer at the option of the holder, making the structure part debt and part equity. Convertible bonds have many similarities to straight debt: they can be interest bearing or zero coupons, senior or subordinated, can contain puts, be callable by the issuer, and have maturities anywhere from 1 year to 30 years. The key difference between straight debt and convertible debt lies in the option of the holder to convert the debt into common stock. This can be viewed then as a straight bond plus an imbedded option to buy the common stock (see part one of this series). The strike price of the option is known as the conversion price and is set at a premium to the stock price at issue.

We will use the Tyco's (TYC:NYSE) January issue of 2.75% convertible bonds due 1/15/18 as an example. When the bond was issued, TYC stock was at $17.26 per share. The conversion price was set at $22.78, a 32% premium to the stock price at issue. The conversion ratio is the number of shares each bond can be converted into and is found by dividing the issue price of the bond by the conversion price. The TYC bonds were issued at $1,000 so the conversion ratio is 43.89 shares ($1,000 / $22.78). The investor can either take the $1000 principal back at maturity or 43.89 shares of stock. If the value of those 43.89 shares is greater than $1000 at maturity, the investor will rationally take the shares. The value of the shares an investor can convert into is called parity and is found by multiplying the conversion ratio by the current share price. If TYC stock is at $18, then parity on the bonds would be $790 or 79% of face value. As the price of the stock rises, parity rises and as the stock climbs over the conversion price the total value will exceed $1000.

The coupon on the bonds works just like a coupon on straight debt. With a coupon of 2.75% the TYC bonds pay $27.50 per year, paid semi-annually. The coupon rate issuers pay on convertible bonds is less than the coupon they would pay pari passu on straight debt because investors are willing to accept a lower coupon in exchange for the right to convert the bonds into shares (value of the imbedded option). If the stock rises in price above the conversion price, the convertibles will outperform the straight debt (due to the convertibility) and under-perform the common stock (due to the premium paid). If the stock drops below the conversion price, the convertibles will outperform the common stock (due to ability to receive par at maturity) and under-perform the straight debt (due to the lower coupon).

Most new structured products are variations of others. An example is convertible preferred securities, which are very similar to convertible bonds with the only difference being the ranking of the security in the capital structure and the maturity (typically 30 years or longer). They pay dividends as opposed to coupons and are convertible just like convertible bonds.

Another variation is mandatorily convertible preferreds (mandatories), which are one of the most issued structured securities in the public markets. The reason for their highly structured nature is tax and accounting related and pertains to the issuer. We will skip over those details and focus on investor concerns. Mandatories are typically issued at $25 or $50 par and pay a dividend of approximately 6% to 10%. As their name suggests, mandatories automatically convert to stock at maturity, typically three to five years from the issue date. The conversion rate for a mandatory varies depending on the stock price at maturity.

As a generic example, assume a company issues a mandatory with a $50 par value and the stock of the issuer is $25 at issue. Also assume the mandatory has a 20% conversion premium and pays a 7% dividend ($3.50 per year paid quarterly). The conversion ratio at maturity is as follows:



The following is a comparison of the value at maturity of the mandatory versus the value at maturity of 2 shares of common stock, the number of shares an investor could have purchased if they spent $50 on common instead of the mandatory.



In the graph of conversion value at maturity, it is obvious that the mandatory holder underperforms the stock holder on the upside (stock above $25) and performs equally with stock prices below $25. This however does not factor in the present value of the dividends received by the investor. Once these are factored in, the line will shift up by that present value amount and the mandatory holder will outperform the stock on the downside and when the stock doesn't appreciate significantly and under-perform the stock if the price rises significantly. Basically a mandatory is a convertible bond plus an embedded call spread (the investor is short a slightly out-of-the-money call and long more than one higher strike calls). The spread causes the bond to be mandatorily converted into stock at maturity.

There are two typical investors in convertible securities whose behavior is very different. Outright investors purchase convertible bonds for their downside protection (debt similarity) and purchase convertible preferreds and mandatories for their yield and stock sensitivity. Outright investors are making bets on the equity and will typically not hedge their positions. Arbitrage investors such as hedge funds purchase convertible bonds to take advantage of the stock volatility (embedded option) and preferreds and mandatories for their yield advantage to the underlying common. Arbitrageurs will typically short stock to hedge their positions and may also purchase credit derivatives to further protect themselves on the debt portion. The arbitrager is focusing on extracting the relative value of the imbedded options.

It is typical for the stocks of companies that issue convertibles to fall a bit when they announce a new deal. This drop is part due to the implied stock dilution if the convertibles were converted and part due to arbitrageurs who will short stock going into pricing so they can hedge their stock risk. Other types of investors who purchase convertible bonds are distressed debt funds, corporate debt funds and some individual investors.

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No positions in stocks mentioned.

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