LYONs may seem to provide the best of all worlds, but they have some negative aspects.
LYONs provide downside protection via the put option feature and full participation in the equity kicker.
Zero coupon bonds don't generate current income.
The put option is something investors should watch out for.
ThePayout can be in stocks or bonds depending on the type of put option.
The conversion price on the stock increases over time because the conversion ratio on the LYON is fixed.
The zero coupon bond's value increases as it matures.
If the market price of the stock goes up more than the bond's rate of appreciation, investors will never be able to convert their LYONs.
Because convertibles are fixed-income securities linked to the equity position of the firm, they are normally valued in terms of both the stock and bond dimensions of the issue.
When considering convertibles as an investment outlet, it is important to analyze the underlying common stock and interest rate expectations.
The stock dimensions are the first thing we'll look at.
When the market price of the stock gets close to the conversion price, convertible securities trade like common stock.
The price behavior of the convertible will match that of the common stock when that happens.
If the stock price goes up, so does the convertible.
The rate of change in price of the convertible will exceed that of the common because of the conversion ratio.
The price of a convertible will move in the same direction as the price of the common stock if the conversion ratio is 20.
When a convertible trades as a stock, its market price will affect a multiple of the share price of the common with the size of the multiple being defined by the conversion ratio.
Market rates of interest are the focus of investors.
The equity kicker and low agency ratings of convertibles make them a good choice for the upside.
Gaining more than a rough Convertibles is very popular in the idea of what the prevailing yield of a convertible obligation should be.
The quality prices move more like stocks than bonds if the issue is rated Baa.
Because of the interest and stock that underlies the cipal payments that they offer, convertible bonds essentially have a price floor, meaning that they can't drop as much as the underlying bond's conversion price.
If a company experiences financial problems that cause its stock price conversion feature to be nearly irrelevant, the firm's convertible bonds will retain much of their value, because investors are still entitled to receive interest and principal payments.
The price of the convertible will not fall to less than its price floor because it is like a bond.
In order to evaluate the investment merits of convertible securities, investors should consider both the bond and stock dimensions of the issue.
The key role the equity kicker plays in defining the price behavior of a convertible is an important part of the fundamental security analysis of the equity position.
Market yields and agency ratings are used to evaluate the bond side of the issue.
It is essential to evaluate the conversion feature in order to analyze the bond and stock dimensions of the issue.
Conversion value and investment value are critical areas.
These measures can have a dramatic effect on an issue's holding period return because they have a vital bearing on a convertible's price behavior.
A conversion ratio of 20 is the current market price of the stock.
The conversion equivalent is the price at which the common stock would have to be sold in order to make the convertible security worth its current market price.
If a convertible bond has a current market price of $1,400 and a conversion ratio of 20, the conversion equivalent of the common stock would be $70 per share.
You would expect the current market price of the common stock to be at or near $70 per share in order to support a convertible trading at $1,400.
Convertible issues rarely trade at their conversion values.
They usually trade at prices that exceed the bond's conversion value.
The size of an issue's conversion premium is found by taking the difference between the convertible's market price and its conversion value.
Simply divide the conversion premium by the issue's conversion value to place it on a relative basis.
The conversion premium is the value where the conversion value is found.
The conversion value of a convertible bond is $1,200 if it trades at $1,400.
The $200 conversion premium is 16.7% of the bond's conversion value.
In the market, conversion premiums can be 30% to 40% of an issue's conversion value.
The convertible's upside potential is one of the reasons why investors are willing to pay a premium.
An investor can recover this premium either through the added current income or by selling the issue at a premium equal to or greater than that which existed at the time of purchase.
The conversion premiums fade away as the price of the convertible goes up, so it's hard to find the latter source of recovery.
If an investor purchases a convertible for its potential price appreciation, then he must accept the fact that a large portion of the price premium is very likely to disappoint as the convertible appreciates over time and moves closer to its true conversion value.
If he wants to recover the conversion premium, he will have to come from the added current income that the convertible provides.
The size of the conversion premium can affect investor return.
One of the questions inves tors should ask is whether the premium is justified.
It makes sense to use the added income to assess the premium because it is a principal reason for the conversion.
The bond's conversion ratio is used to find the stock's latest annual dividends per share.
The previous example had a conversion premium of $200.
The underlying stock paid dividends this past year of 50 cents a share and the bond has an 8.5% coupon.
You can use Equation 10.8 to find the payback period.
You would get the premium back in a relatively short period of time.
The shorter the payback period, the better.
Also, watch out for excessively high premiums.
There are fixed-income securities for convertibles that have payback periods of five to seven years.
When using this measure, be careful.
Some convertibles have high payback periods because they have low coupons.
The focus of the investment value measure is the price floor of a convertible.
Current and expected market interest rates are the focus of the valuation process.
We will cover the mechanics of bond pricing in more detail later, but suffice it to say that the investment value of a convertible is found by taking the issue's coupon stream and par value back to the present, using a discount rate equal to the prevailing yield on comparable non If you use the yields on comparable nonconvertible bonds as the discount rate, find the present value of the convertible's coupon stream, add that to the present value of its par value, and you have the issue's investment value.
Because the convertible's coupon and maturity are known, the only additional information needed is the market yield of similar rated issues.
If comparable nonconvertible bonds were trading at 9% yields, we could use that 9% return as the discount rate to find the present value of a convertible.
A financial calculator can be used to find the investment value of a 20-year, $1,000 par value convertible bond with a 9% discount rate.
Explain how the equity kicker affects the value of a convertible security.
You should know what to know after reading this chapter.
Current income and capital gains are the two basic sources of return for publicly traded debt securities.
Current income comes from the coupon payments received over the life of the issue.
Capital gains can be made when market interest rates fall.
Bonds can be used to shelter income from taxes.
Diversification of bonds can enhance portfolio stability.
The issuer will pay the problem.
The bond market prices are quoted as a percentage of par and are driven by the issue's coupon and maturity.
When interest rates go down, bond prices go up.
Bond prices can move up or down depending on the coupon and maturity of the issue.
Larger price swings can be created by bonds with lower coupons or longer maturities.
Treasury bonds are issued by the U.S. Treasury.
Foreign bonds offer attractive yields and returns.
Foreign-pay bonds cover issues that are not in the U.S. dollars.
Currency exchange rates are an added source of return.
Yankee bonds and Eurodollar bonds have no currency exchange risk because they are issued in U.S. dollars.
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The returns on Treasury bonds during the 1970s and 1980s were different.
Assume that you have a well-paying job after graduating from school.
The investor's desire is described in the right-hand column.
Generate a monthly income.
Avoid a lot of price fluctuations.
LYONs are different from conventional convertible securities.
You can use the resources at your campus or public library.
Determine the conversion ratio, conversion parity, conversion value, conversion premium, and payback period for each of the two convertible bonds you choose.
Determine the conversion ratio, conversion parity, conversion value, conversion premium, and payback period for each of the two convertible preferreds.
The bond can be called in two years at a call price of $2,000.
The market price for the bond is $1,770.
A bond has a current yield of 8.1% and a market price of $925.
A 12% corporate bond has a current yield of 8%.
An investor with a 28% tax rate lives in a state with no income tax.
He is trying to make a decision.
A 7.5% corporate bond is selling at par.
There is a municipal bond with a coupon that is also selling at par.
An investor lives in a state with a tax rate.
Her federal income tax rate is 28%.
She wants to invest in bonds that are similar in terms of risk, and both bonds currently sell at par value.
The first bond has a yield of 8%.
The second bond has a yield of 5% and is exempt from both state and federal taxes.
Maria Lopez is a wealthy investor.
Maria lives in a state that has a very high state income tax.
Maria is looking at two bonds that are selling at par.
One of the bonds has a coupon of 6 3/8 %.
The AA-rated bond has a 7 percent coupon.
She was told by her broker that comparable fully taxable corporate bonds are currently available.
Long Treasuries have a yield of 9%.
She wants to maximize her after-tax returns because she has $100,000 to invest, and all the bonds are high-quality.
Someone is looking for a fixed-income investment.
An in-state municipal bond with a yield of 2% is in the federal tax brackets.
Elena bought a Spanish government bond a year ago with a 5% coupon.
Interest rates plummet over the course of the next year.
She sold the bond at the current price.
One year ago and today, find the current yield on this bond.
Elena's HPR return should be calculated in euros.
A current yield of 5% is what the 8% corporate bond has.
The current yield on the bond is six percent when she sells it one year later.
You bought $30,000 worth of bonds in January of 2010.
The bonds had a coupon of 8 percent and were due in 2024.
You paid 94.125 for the bonds.
The five-year period saw coupon payments on time.
To evaluate the investment performance of this bond, use the return information in Table 10.
15 years ago, Rhett purchased a zero-coupon bond with a 15-year maturity and $20,000 par value.
Tomorrow is when the bond matures.
Nate bought an interest-bearing security last year and was going to hold it until maturity.
The principal was paid back in the first year after he received interest payments.
This happened again in the second year.
Letticia is currently thinking about investing in a foreign government bond.
She's looking at a Swiss government bond that matures in 15 years and has a 9 1/2 % coupon.
The bond has a par value of 10,000 Swiss Francs and is currently trading at 110% of par.
She expects bond prices to move up when she holds the bond for one year, because she expects a decline in Swiss interest rates.
She expects the exchange rate to fall from 1.58 to 1.25.
The foreign investment total return formula can be used to find this information.
If you ignore the currency effect, you can find the bond's total return.
Find the total return in U.S. dollars.
Red Electrica Espana SA is issuing Eurobonds to investors.
If you buy $8,000 worth of these bonds, you will get a 7% yield.
A U.S. bond with similar risk will yield 4%.
You expect interest rates to stay the same over the course of the next year, after which you will sell your bonds.
The dollar/euro exchange rate should go from 1.3 to 1.0.
A convertible bond has a conversion ratio of 21 and a conversion premium of 20%.
The underlying common stock has a market price of $40.
You are considering investing a lot of money.
The stock of Technology Inc. pays no dividends.
A $1,000 par value convertible bond is currently trading at $790 and has a conversion ratio of 30.
It pays 40 per year in interest.
The holder of the convertible bond has the option to convert it into 20 shares of common stock.
The bond is currently trading at a high price.
The stock pays 75C/ a share in annual dividends and is currently priced at $35 a share.
You plan to invest in France Telecom SA's convertible bond with a par value of 1,000 and then convert it into Orange SA shares with a conversion ratio of 20.
The convertible bond has a coupon of 2.5% and a conversion premium of 15%.
The current price of the underlying Orange SA common stock is calculated.
You paid $1,200 for a convertible bond that has a 7 1/2 % coupon and has 15 years to maturity.
24 shares of stock can be converted into the bond, which is currently trading at $50 a share.
Compare the investment value of this issue to the yield on comparable nonconvertible bonds.
Determine the conversion premium of a convertible preferred stock that sells in the market for PS755 and carries a conversion ratio of 2, given the market price of the underlying common stock is PS353 a share.
The conversion parity of the convertible is given by the preferred trades at PS755 per share.
Max and Veronica Shuman, along with their two teenage sons, Terry and Thomas, live in Portland, Oregon.
Veronica is a personnel officer at a local bank, while Max is a sales rep for a major medical firm.
They make an annual income of $100,000.
Max learned that his uncle had left him $250,000 in his will.
The family is overjoyed.
Max wants to spend $50,000 of his inheritance on a number of family items, including a badly needed remodeling of their kitchen and family room, the down payment on a newPorsche Boxster, and braces to correct Tom's overbite.
Max wants to invest the rest of the money in fixed-income securities.
Max and Veronica don't have any health problems.
They only have two investment objectives, one of which is to achieve some capital appreciation and the other is to keep their funds invested for at least 20 years.
They don't want to rely on their investments as a source of current income, but they do want to have some liquid assets in case.
Do you think the Shuman family should invest in bonds?
Consideration should be given to both return and risk factors when answering this question.
List several types of bonds that you would recommend for their portfolio.
I invest in fixed-income securities.
The portfolio must include at least one Treasury, one agency, and one corporate bond, as well as five but no more than eight bonds or notes.
If you hold a T-bill, that limits your selections to just seven other notes/bonds, so no more than 5% of the portfolio can be in short-term U.S. Treasury bills.
Ignore transaction costs and assume all securities have a par value of $1,000.
You can use the latest available quotes to figure out how many bonds you can buy.
All the securities in your recommended portfolio should be listed in a schedule.
The form shown below can be used to include information on each security in the portfolio.
The investment objectives you hope to achieve with your recommended portfolio should be noted in a single paragraph.
The underlying financial condition and operating results of the company issuing the bond are the most important factors in determining a bond's rating.
Just as financial ratios can be used in the analysis of common stocks, they can also be used in the analysis of bonds.
The ability of the firm to service its debt, the extent to which it employs debt, and the basic profitability of the firm are all considered in credit analysis.
The financial ratios shown in the preceding table can be used to carry out such analysis.
The ability of the firm to service its debt load is measured by the final two ratios.
The ratios are listed in the table.
Three of these companies have bonds with investment-grade ratings.
The companies have junk-bond ratings.
One of the companies is a B-rated firm.
Explain your selections.
One of the companies has an AA rating, one has an A rating, and two have aBB rating.
Bond cash flows are discounted back in order to determine their present value, just like other time-value-of-money considerations.
Many investors look at the returns of bonds and stocks.
Current income and capital gains make up the total returns in the bond market.
Bond investment analysis should include the current yield and holding period return.
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