KYNEX Bulletin                                  

October 2009

 

In this issue we discuss and give insight into valuation of provisional calls, mandatory convertibles, variable conversion ratios, and conversion price resets that require averaging periods and stock history.

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Provisional Triggers and Averaging in Convertible Valuation

 

We are pleased to announce the release of a few enhancements to our convertibles valuation model. Our calculator now supports the use of the stock history in the valuation of convertibles with provisional calls, mandatory convertibles, convertibles with variable conversion ratios (also known as “embedded warrants” or “hyper-structures”), and conversion price reset features.

 

  • For a provisionally callable convertible, the effect of the stock history can be significant if the stock has been trading close to the trigger level, and only a few more days are required to pass the “20 out of 30 trading days” threshold for a provisional call.
  • The cases of variable conversion ratios, mandatory convertibles and convertibles with conversion price resets, all share the common feature that the conversion ratio (on the warrant expiration date, or a reset date, etc) is set based on the average stock price over the previous N trading days (where “N” may be 10 or 20, etc.). If the stock history has been trending upwards or downwards significantly, then the average stock price can be significantly different from the current underlying spot price.

 

We summarize noteworthy aspects about the different types of convertibles below. More details are given in separate sections later in this bulletin.

 

  • Provisional Call
    • It is possible that if a provisionally callable bond is not called by the issuer when the threshold is met, the bond may cease to be callable at a later date as the stock prices drop below the threshold. This was in fact the case for the bond HAS 2.5%, due December 1, 2021. The bond was callable in January 2009, up to January 26, 2009, but not from January 27, 2009 into February 2009. An analysis of this bond is given below.
    • Depending on the stock price history, the sensitivities of a provisionally callable convertible can be significantly affected. As the stock history approaches meeting the threshold for the call, delta rapidly approaches 100, median life rapidly approaches call notice period, and the fair value approaches parity plus any potential make-whole amounts.

 

  • Mandatory Convertible
    • The stock price history is only relevant if the settle date is within twenty days of the maturity of the mandatory.
    • The stock price history is used solely to establish the applicable conversion ratio on the maturity date. The actual parity (or terminal fair value) of the bond will depend on the underlying spot price on the maturity date and the computed conversion ratio based on the average stock price.
    • If the stock is trading in a narrow range, the average stock price will not be much different from the current spot price on the trade date. However, if the stock price is trending (upwards or downwards), then there could be a significant difference between the average stock price and the current spot price, so the terminal conversion ratio will be significantly different from a value calculated based only on the terminal spot price.

 

  • Variable Conversion Ratio (Embedded Warrants)
    • The adjustment to the conversion ratio takes place on the warrant expiration date, and remains in effect for the remainder of the life of the convertible.
    • If the convertible is callable, and there is also a put, on the same date as the warrant expiration date, then typically the valuation model will predict that the bond will terminate on that date (either a call by the issuer, or a put or voluntary conversion by the investor). However, there are several issues where the embedded warrants expire on the maturity date on the convertible. An example is LNCR Tranche B 2.75% (due November 1, 2037). Note that this bond has a put on November 1, 2014, which is also the first call date (unconditional call). The valuation model predicts that the bond will terminate on November 1, 2014, and the median life of the bond goes up to this date. However, if for any reason the bond does not terminate on November 1, 2014, then the conversion price calculated on that date will remain in effect until 2037.

 

  • Conversion Price Reset
    • The stock price history is only relevant if the settle date is within ten days of the next upcoming reset date.
    • If the average stock price is far below the floor price, or far above the current conversion price, then the reset of the conversion price (if any) will be predictable. (Our observation is that this is generally the case.)  However, if the average stock price is between the floor and the current strike, then the valuation of the convertible will be significantly affected by the stock price average.

 

COMPLETE ARTICLE

 

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