CONVERTIBLE BONDS – What to put in presentation & report – FINANCIAL BACKGROUND SUMMARY

1. Introduction – stocks and bonds:

Stocks Are Ownership Stakes; Bonds are Debt

Investors are always told to diversify their portfolios between stocks and bonds, but what’s the
difference between the two types of investments?

Stocks and bonds represent two different ways for an entity to raise money to fund or expand their
operations. When a company issues stock, it is selling a piece of itself in exchange for cash. When an
entity issues a bond, it is issuing debt with the agreement to pay interest for the use of the money.

A stock is a share in the ownership of a company and represents a claim on the company's assets
and earnings – meaning the owner shares in the profits and losses of the company. Overall, stocks
tend to be on the risker end of the investment spectrum in terms of their volatility and the risk that
the investor could lose money in the short term. However, they also tend to provide superior long-
term returns. Stocks are therefore favoured by those with a long-term investment horizon and a
tolerance for short-term risk.

A bond is a fixed income instrument that represents a loan made by an investor to a borrower
(typically corporate or governmental) – and are a form of borrowing with debt obligations and must
be repaid over time. Bonds lack the powerful long-term return potential of stocks, but they are
preferred by investors for whom income is a priority. Also, bonds are less risky than stocks. The vast
majority of bonds tend to pay back the full amount of principal at maturity, and there is much less
risk of loss than there is with stocks.
Stocks or bonds? For income-focused investors, why not blend the best of both worlds to collect
interest and enjoy share price upside?
This is the goal of convertible bonds

2. Introduction – convertible bonds

Convertible bonds (CBs), complex in nature, are widely used hybrid financial instruments. They are
different from bonds and stocks, and yet with some combining characteristics of bonds and options.
During the life of a convertible bond, the holder can choose to convert the bond into the stock of
issuing company or financial institution with a pre-specified conversion price, or hold the bond till
maturity to receive coupons and the principal prescribed in the purchase agreement.

Convertible bonds are corporate bonds that investors are able to convert to a set number of shares
of the issuer’s common stocks. As a result of this potential for growth, the coupon might be
relatively lower than that offered for a similar non-convertible bond. The stock price at which a
convertible bond can be exchanged for share of common stock is called the conversion price.
Conversion ratio – the number of shares of common stock for which a convertible bond may be
exchanged.

Similar to regular bonds, a convertible bond comes with a maturity date and pays interest to
investors. In addition, if an investor decides not to convert their bonds to equity, they will receive
the bond’s face value at the maturity. However, if an investor converts the bonds to the company’s
shares, the bonds will lose all its debt features and will possess only equity features.

Companies with a low credit rating and high growth potential often issue convertible bonds. For
financing purposes, the bonds offer more flexibility than regular bonds. They may be more attractive
to investors since convertible bonds provide a growth potential through future capital appreciation
of the stock price.

(https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/convertible-bond/)

Few investors look closely at convertible bonds, but these investments can be ideal for those looking
for a combination of reliable income and potential capital appreciation. Convertible bonds are fixed-
income debt securities that companies issue to raise capital, and they pay interest at regular
intervals. What sets convertible bonds apart from most debt securities is that the owner can convert
their bond holdings into a certain number of shares of common stock of the issuing company. That
feature gives convertible bonds much greater upside than regular bonds, and for that reason, most
investors treat convertible bonds as a hybrid between a fixed-income investment and a stock
investment.

**Vanilla convertible bonds: They are the most common type of convertible bonds. Investors are
granted the right to convert their bonds to a certain number of shares at a predetermined
conversion price and conversion rate at the maturity date. Vanilla convertible bonds may pay
coupon payments during the life of the bonds and comes with a fixed maturity date at which the
investors are entitled to the nominal value of the bond.
Others include Mandatory convertibles, which provide investors with an obligation to convert their
bonds to the shares at maturity and Reverse convertibles, which give the issuer an option to either
buy back a bond in cash or convert a bond to the equity at a predetermined conversion price and
conversion rate at the maturity date.

3. Advantages:

Corporations may enjoy some advantages by issuing convertible bonds. As mentioned before, these
bonds typically have lower interest rate, reducing the amount issuers must payout to investors. Also,
when bonds are converted to common stocks, the issuer no longer has to make fixed interest
payments, which ultimately reduces its debt. Another advantage to issuing convertible bonds as
oppose to common stock is that doing so does not instantly increase issuer’s number of outstanding
shares, which would otherwise reduce earning per share.

Sharing qualities of both fixed income and equity securities, convertible bonds offer investors some
unique benefits. For instance, bond holders that have not initiated a conversion maintain a
precedence over common stock holders in terms of liquidation. Also, if this security is not converted,
CB continues to pay a fixed rate of interest and a par value is returned at maturity, except ofc in case
of default. Typically, these interest payments have a higher priority of payment than dividend
payments to which holders of common stock may be entitled to. Should the investor decide to
exchange convertible bonds for common stock, he/she can do so with no official tax obligation, as
such a conversion of bond to stock is not deemed to be buying and selling from a taxation
perspective.

In some ways, convertible bonds offer investors the best of both worlds. The price of convertible
bonds is tied to their two very different markets. The bond component of the convertible bond
responds to changes in credit quality and interest rates. The stock component rises and falls along
with the share price of the company's common stock.

Whether a convertible bond acts more like a bond or a stock depends on how the share price of the
common stock relates to the conversion price stated in the bond. For instance, if a $1,000 bond is
convertible into 50 shares of common stock, then the conversion price is $1,000 divided by 50, or
$20 per share. If the share price is well below $20, then the conversion feature of the convertible
bond isn't very valuable, and so the security acts more like a bond. If the stock climbs well above
$20, then the stock aspect of the convertible bond is its primary value, and so the convertible bond
will move more in line with the stock.

Many investors never choose to look more closely at convertible bonds because of the difficulties in
finding and buying them. Yet those who expend the extra effort can get access to a unique type of
investment that can have exactly the features that many investors want for their portfolios.

(https://www.fool.com/knowledge-center/what-is-a-convertible-bond.aspx)

Convertible bonds are a flexible option of financing that offers some advantages over regular debt or
equity financing. Few benefits from the issuance of convertible bonds include:

1. Lower interest payments

Generally, investors ask for lower interest payments on convertible bonds than on regular bonds.
Thus, issuing companies can save money on their interest payments.

2. Tax advantages

Since interest payments are tax-deductible, convertible bonds will allow the issuing company to
benefit from interest tax savings that are not possible in equity financing.

3. Deferral of stock dilution

If a company is not willing to dilute the shares in the short or medium term but is comfortable to do
it in the long term, convertible bonds financing is more appropriate than equity financing. The
current company’s shareholders will retain voting power and they may benefit from the capital
appreciation of its stock price in the future.

(https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/convertible-bond/)

Because of their hybrid nature, the valuation of CBs can be much more complicated than that of
simple options, especially when the additional complexity such as the callability and putability or the
issue of default risk of the issuer is added to the valuation task.

Let V (S,t) denote the value of a convertible bond, S be the price of the underlying asset and t be the
current time. Then, under the Black-Scholes framework (see Black and Scholes, (1973)), the value of
a convertible bond V should satisfy the partial differential equation

where r is the risk-free interest rate, σ is the volatility of the underlying asset price and D0 is the rate
of continuous dividend paid to the underlying asset. In this paper, r and σ are assumed to be
constant. Eq. (1) needs to be solved together with a set of appropriate boundary conditions and the
terminal condition.

However, most of the convertible bonds issued are of American style, conversion is allowed at any
time prior to the expiry of the CB, just like American options. For these American-style CBs, the
boundary condition at infinity should be replaced by two conditions
where Sf(t) is a moving boundary which needs to be found as part of the solution. This paper focuses
on the valuation of CBs with American-style conversion

The essential difficulty for this problem lies in the fact that once conversion is allowed to take place
prior to the expiry, there is an optimal value of the underlying asset, at which the holder of CB
should convert the CB into the underlying asset. Mathematically, like the problem of valuing
American options, the problem becomes highly nonlinear because the problem has been turned into
a free boundary value problems.

Flexibility in conversion time: Mathematically, this early exercise

right has changed the problem into a free-boundary problem.

The optimal exercise price prior to the expiration of the CB is

now time-dependent and is part of the solution.

Thus, the problem becomes highly non-linear.

•
This nonlinear feature leads to the difficulty in looking for an
exact analytical solution, as there are no set methods to solve.
Laplace transform has been introduced to attempt to solve the problem since Laplace transform can
be a powerful in solving partial differential equations, deal with the boundary conditions of a PDE on
an infinite domain. We can also make use of pseudo-steady-state approximation, which is used in
the performance of the Laplace transform, to convert the systems of partial differential equations to
systems of ordinary differential equations in the Laplace space.

The treatment of the two nonlinear moving boundary conditions in requires an approximation

based on the pseudo-steady-state approximation used in the heat transfer for Stefan problems.
Based on the pseudo-steady-state approximation, if we assume that the optimal exercise boundary
moves slowly in comparison with the “diffusion” of the option price, S can still be held as a constant
during the Laplace transform and will then be replaced by the Laplace transform performed on the
interfacial condition S = Sf (τ ) with S being held as a constant as well.