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.
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ARTICLE
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