A significant segment of the Eurobond market is made up of convertible bonds. Convertibles (and warrants) are instruments that have option features attached to them, issued primarily by corporates but also sometimes by governments. The option attachments act as a further inducement for investors, and serve to make the instrument easier to sell than a plain-vanilla bond issued by the same company.

A convertible bond is a bond that can be converted at the option of the holder into the ordinary shares of the issuing company. Once converted into ordinary shares, the shares cannot be exchanged back into bonds. The ratio of exchange between the convertible bond and the ordinary shares can be stated either in terms of a conversion price or a conversion ratio. For example, ABC plc’s 10% convertible bonds, with a face value of £1,000, may have a conversion price of £8.50, which means that each bond is convertible into 117.64 ordinary shares. To obtain this figure we have simply divided the face value of the bond by the conversion price to obtain the conversion ratio, which is £1,000/£8.50 = 117.64 shares. The conversion privilege can be stated in terms of either the conversion price or the conversion ratio. Conversion terms for a convertible do not necessarily remain constant over time. In certain cases convertible issues will provide for increases or step-ups in the conversion price at periodic intervals. A £1,000 denomination face value bond may be issued with a conversion price of, say, £8.50 a share for the first 3 years, £10 a share for the next 3 years and £12 for the next 5 years and so on. Under this arrangement the bond will convert to fewer ordinary shares over time which, given that the share price is expected to rise during this period, is a logical arrangement. The conversion price is also adjusted for any corporate actions that occur after the convertibles have been issued, such as rights issues or stock dividends. For example, if there was a 2 for 1 rights issue, the conversion price would be halved. This provision protects the holders of convertible bonds and is known as an anti-dilution clause.

We have already referred to the conversion ratio, which defines the number of shares of common stock that is received when the bond is converted; and the conversion price is the price paid for the shares when conversion takes place.

(7.1)

The percentage conversion premium is the percentage by which the conversion price exceeds the current share price. Let us assume a convertible with a conversion ratio of 20 (i.e., 20 shares are received in return for the bond with a par value of £100) and therefore a conversion price of £5.00. If the current price of the share is £3.70, then we have:

The conversion value of the bond is given by:

This shows the current value of the shares received in exchange for the bond. If we say that the current share price is again £3.70, then the current conversion value is given by:

If the bond is trading at 82.50 (per 100), then the percentage conversion price premium, or the percentage by which the current bond price exceeds the current conversion value, is given by (7.3):

In our example:

A convertible can be viewed as a conventional bond with a warrant attached to it. Its fair price will therefore be related to the price of a vanilla bond and the price of a call option, taking into account both the dilution effect of the new shares that are issued and the coupon payments that are saved as a result of conversion.

The proportionate increase in the number of shares outstanding if all the bonds are converted, referred to as q, is given by (7.4):

The fair price of the convertible is given by (7.5): where

The price of the vanilla bond is calculated in exactly the same way as a standard bond in the same risk class.

Expression (7.5) will give us the fair price of a convertible if the bond is not callable. However, some convertibles are callable at the issuer’s option prior to the final maturity date. The issuer can therefore force conversion when the share price has risen to the point where the value of the shares received on conversion equals the call price of the bond. Since the firm has a clear incentive to call the bond when this occurs, the call price puts an effective ceiling on the price of the convertible given in (7.5).

It is possible to calculate the likely call date for a callable convertible by using the expression at (7.6): where

Let us then assume that the call price of the bond is £110 (i.e., £10 over par or face value), the conversion ratio is 20 and the current share price is £3.70 and is growing at 8.25% per year. Given that the right-hand side of expression (7.6) is the conversion value of the convertible in t years’ time, it can be seen using (7.6) that the conversion value will equal the call price in 5 years. Therefore, the bond is likely to be called in 5 years’ time.

If we look again at (7.5), and using our assumed terms and values, we can see that the price of the convertible depends on the price of a vanilla bond with 5 years to maturity (and a terminal value of £110) and a call option with 5 years to expiry. If we say that the vanilla bond has a fair price of 63.30, the call option has a premium of £1.20, and the proportionate increase in the number of shares is 25 %, then the fair price of the convertible is shown below:

The attraction of a convertible for a bondholder lies in its structure being one of a combined vanilla bond and option. As we shall see in our introductory discussion of options, option valuation theory tells us that the value of an option increases with the price variance of the underlying asset. However, bond valuation theory implies that the value of a bond decreases with the price variance of the issuer’s shares, because the probability of default is increased. Therefore, attaching an option to a bond will act as a kind of hedge against excessive downside price movement, while simultaneously preserving the upside potential if the firm is successful, since the bondholder has the right to convert to equity. Due to this element of downside protection, convertible bonds frequently sell at a premium over both their bond value and conversion value, resulting in the premium over conversion value that we referred to earlier. The conversion feature also leads to convertibles generally trading at a premium over bond value as well; the higher the market price of the ordinary share relative to the conversion price, the greater the resulting premium.

Zero-coupon convertible bonds are well-established in the market. When they are issued at a discount to par, they exhibit an implicit yield and trade essentially as coupon convertibles. Similarly, if they are issued at par but redeemed at a stated price above par, an implicit coupon is paid and so again these bonds trade in similar fashion to coupon convertibles. A zero-coupon bond issued at par and redeemed at par is a slightly different instrument for investors to consider. With these products, the buyer is making more of an equity play than he is with conventional convertibles, but with an element of capital protection retained.

A buyer of a par-priced zero-coupon convertible will have the view that the underlying equity has high upside potential, and will believe that this is worth the negative yield that is earned on the bond. However, the equity will have high volatility, so the convertible route is still lower risk than the pure equity route; the investor pays an opportunity cost in terms of interest foregone in order to retain greater safety compared with pure equity. The softcall option is often built in so that the issuer can force conversion if the equity has performed as expected, which caps the investor’s upside. In many cases, zero-coupon convertibles are issued in one currency but reference shares denominated in another (less liquid) currency, so that investors can have exposure to the equity without having to hold assets in the less liquid currency.

With par-priced zero-coupon convertibles buyers often are taking a view on equity price volatility, rather than equity price per se, and the value of the note will increase if volatility increases. In such a trade the investor benefits if volatility increases. For issuers, the advantage of zero-coupon par-priced convertibles is even greater than that afforded by conventional convertibles: they receive no-cost funding compared with a normal bond or loan. In return they are selling (for them) a cheap route to their equity should the share price perform.

A warrant is an option issued by a firm to purchase a given number of shares in that firm (equity warrant) or more of the firm’s bonds (bond warrant), at a given exercise price at any time before the warrant expires. If the warrant is exercised, the firm issues new shares (or bonds) at the exercise price and so raises additional finance. Warrants generally have longer maturities than conventional options - 5 years or longer, although these days it is not difficult to trade very long-dated over-the-counter (OTC) equity options - and some warrants are perpetual.

Warrants are usually attached to bonds (host bond) to start with; in most cases such warrants are detachable and can be traded separately. Equity warrants do not carry any shareholder’s rights until they are exercised - for example, they pay no dividends and have no voting rights. Bond warrants can either be exercised into the same class of bonds as the host bond or into a different class of bond. In valuing a warrant it is important to recognise that exercising the warrant (unlike exercising an ordinary call option) will increase the number of shares outstanding. This will have the effect of diluting earnings per share and hence reducing the share price. Hence, an equity warrant can be valued in the same way as an American call option, but also taking into account this dilution effect.

As with ordinary options the value of a warrant has two components, an intrinsic value (which in warrant terminology is called the formula value) and a time value (premium over formula value). The formula value is determined by equation (7.7):

If the exercise price exceeds the share price, the formula value is 0 and the warrant is said to be ‘out-of-the-money’. If the share price exceeds the exercise price the warrant is in-the-money and the formula value is positive. The time value is always positive up until expiry of the warrant. As with options the time value declines as the expiry date approaches, and on the expiry date itself the time value is 0.

The fair price of a warrant is given by (7.8): where

A warrant is attractive to investors because if the firm is successful and its share price rises accordingly, the warrant can be exercised and the holder can receive higher value shares at the lower exercise price. Virtually all warrants are issued by corporations and are equity warrants. In the late 1980s the Bank of England introduced gilt warrants which could be exercised into gilts; however, none is in existence at present. It is of course possible to trade in OTC call options on gilts with any number of banks.

Medium-term notes (MTNs) are corporate debt securities ranging in maturity from 9 months to 30 years. As with vanilla bonds the issuer promises to pay the noteholder a specified sum (usually par) at maturity. The unique characteristic of MTNs is that they are offered to investors continually over a period of time by an agent of the issuer. Notes can be issued either as bearer securities or registered securities. The market originated in the US (where the first issue was introduced by Merrill Lynch in 1981 for Ford Motor Credit) to close the funding gap between commercial paper and long-term bonds.

A Euromarket in MTNs developed in the mid-1980s. Euro MTNs (EMTNs) trade in a similar fashion to Eurobonds; they are debt securities issued for distribution across markets internationally. After initial liquidity problems the market grew in size considerably and is now fairly liquid.

Issues of MTNs are arranged within a programme. A continuous MTN programme is established with a specified issue limit, and sizes can vary from $100 million to $2,000 million or more. Within the programme, MTNs can be issued at any time, daily if required. The programme is similar to a revolving loan facility; as maturing notes are redeemed, new notes can be issued. The issuer usually specifies the maturity of each note issue within a programme, but cannot exceed the total limit of the programme.

Interest on MTNs is paid on a 30/360-day basis, the same arrangement for Eurobonds. Within the MTN market there is a variety of structures on offer, including floating-rate MTNs, amortising MTNs and multi-currency MTNs.

Under regulations in the US, any corporate debt issued with a maturity of more than 270 days must be registered with the Securities and Exchange Commission (SEC). In 1982 the SEC adopted Rule 415 which permitted shelf registration of new corporate debt issues. A continuous MTN programme can be registered in this way. The issuer must file with the SEC details on (i) historical and current financial information and (ii) the type and number of securities it plans to issue under the programme. This is known as ‘filing a shelf ’. The adoption of Rule 415 made the administration of continuously offered notes relatively straightforward for the issuer.

MTNs are unsecured debt. A would-be issuer of MTNs will usually seek a credit rating for its issue from one or more of the main rating agencies, such as Moody’s or Standard & Poor’s. The rating is given by the agency for a specific amount of possible new debt; should the issuer decide to increase the total amount of MTNs in issue it will need to seek a review of its credit rating. Because MTNs are unsecured, only the higher rated issuers, with an ‘investment grade’ rating for their debt, are usually able to embark on a revolving facility. There is no liquid market in ‘junk’-rated MTNs.

A liquid secondary market in MTNs was first established in the US market by Merrill Lynch which undertook to quote bid prices to any investor wishing to sell MTNs before maturity, provided that the investor had originally bought the notes through Merrill Lynch. In other words, Merrill’s was guaranteeing a secondary market to issuers that sold notes through it. This undertaking was repeated by other banks, resulting in a market that is now both large and liquid. That said, MTNs are not actively traded and market makers do not quote real-time prices on dealing screens. The relatively low volume of secondary market trading stems from a disinclination of investors to sell notes they have bought, rather than a lack of market liquidity.

The main issuers of MTNs in the US market are:

There is a large investor demand in the US for high-quality corporate paper, much more so than in Europe where the majority of bonds are issued by financial companies. This demand is particularly great at the short- to medium-term maturity end. Because the market has a large number of issuers, investors are able to select issues that meet precisely their requirements for maturity and credit rating. The main investors are:

It can be seen that the investor base is very similar to the issuer base!

A number of US and European banks make markets in MTNs, including Bank of America, Goldman Sachs, Morgan Stanley, Credit Suisse and Citigroup. In the UK active market makers in MTNs include RBoS and Barclays Capital.

A company wishing to raise a quantity of medium-term or long-term capital over a period of time can have the choice of issuing MTNs or long-dated bonds. An MTN programme is a series of issues over time, matching the issuer’s funding requirement, and therefore should be preferred over a bond by companies that do not need all the funding at once, nor for the full duration of the programme. Corporate bonds are preferred where funds are required immediately. They are also a better choice for issuers that expect interest rates to rise in the near future and wish to lock in a fixed borrowing rate for all the funds required.