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If you are new to convertible investing, then this article is for you. What is a convertible security, you ask? A convertible security consists of two components: a “straight” non-convertible debt instrument (bond or preferred stock) and a long-term warrant on its underlying common stock. Corporations issue convertible securities for the same reason that any other security is issued: to raise capital. The big advantage of issuing a convertible security is that it is cheaper to finance. The debt is usually sold with a lower coupon than that on non-convertible, or “straight,” issues with comparable maturities.

The indenture agreement for a convertible bond is virtually identical to the indenture of a straight bond, and the terms for convertible preferred stocks are essentially identical to the terms of straight preferred stocks. In general, convertible bonds are issued in face amounts of $1,000, although some issues have face amounts of $5,000 or $10,000. As with any debt instrument, the issuing company is obligated to pay the coupon rate annually, and repay the face amount at maturity. One exception is zero-coupon bonds. This asset class is generally issued at a deep discount to face value and does not pay cash interest. But interest accumulates over the life of the bonds at a yield that is equivalent to the return achieved by reinvesting the cash distributions of a coupon bond at par. Preferred stocks can be issued for any liquidation value, but the vast majority of issues have liquidation values of $25, $50, or $100.

The big attraction of a convertible security to investors is not its similarity to other fixed-income securities. It is the issue’s ability to participate in the activities of the underlying stock and the option to exchange the security for a stated number of underlying common shares at the holder’s option. This allows participation in the potential appreciation of the common, while usually getting a higher yield than the common dividend pays, a factor that lowers downside risk in convertible securities. Convertible investors willingly accept the lower coupon or dividend rate as a tradeoff for the privilege of having a play on the fortunes of the underlying common.

The upside potential of a convertible is rarely unlimited. At issuance, convertibles usually have some degree of call protection, which prevents the issuing company from redeeming the debt for a certain amount of time. After the period of call protection expires, if the underlying stock rises high enough to push the conversion value above the call price, the company can force conversion into the common stock by calling the issue for redemption. Generally, convertible bonds are usually more likely to be called than preferred stocks, because the forced conversion of debt into equity strengthens the company’s balance sheet without an outlay of cash. To ensure that no cash is expended, a company often waits for the conversion value of an issue to be reasonably above the call price (usually about 15% to 20% higher) to protect itself against a decline in the common’s price after the call announcement is made, which would force the company to redeem the issue for cash.

Evaluating the Components of a Convertible

Since convertibles are hybrids of two components- a straight bond or preferred stock and a non-detachable warrant-we can evaluate each component separately. Let us look at the two components for the Hasbro 2.75% convertible bond due 2021, currently ranked 1 and recommended for purchase. The following price relationships and values are as of our March 13, 2009 pricing date.

Market Price: $1,134.40

Investment Value: $ 890.00

Conversion Ratio: 46.296

Conversion Value: $1,076.40

Stock Price: $23.25

Call Price: $1,000.00

Callable: 12/01/21

Prem over Conversion Value: 5%

Prem over Investment Value: 27%

In Column 38, on pages 6 through 23, we list our model’s estimate of an issue’s investment value; that is, its value as a straight debt instrument. (Please note: all price values for bonds in this publication are/is listed as a percentage of par ($1,000) and all preferred price values are in dollars.) An issue’s investment value is based on a number of features, including coupon rate, date of maturity, investment grade, outlook for the company’s financial strength, and any special features such as call terms or put features. In addition, the calculation of an issue’s investment value takes into account its yield to maturity, which will often differ from an issue’s current yield depending on whether the issue is trading at a discount or premium to par. Furthermore, some convertibles have put features—the ability of the holder to sell the bond back to the company on a specific date—which is also taken into account. Calculating an issue’s estimated investment value can be tricky.

Once an issue’s investment value is determined, the value of the warrant portion can be easily calculated by subtracting the investment value from the convertible’s market price. As per our example: the warrant portion of this issue is calculated to be $244.40 ($1,134.40 - $890.00). To calculate the per-share warrant value, simply divide the warrant value by the conversion ratio, which comes to $5.28 ($244.40/ 46.296).

Analyzing the Warrant’s Value

Calculating the price per share of a convertible’s warrant portion is a simple undertaking, as per our example. The tougher question is, does this represent a fair price? To value the warrant portion of a convertible’s issue, we need to know the underlying stock’s expected volatility, the warrant’s strike price, and the issue’s time to maturity and expected time to call (the most difficult factor to estimate).

To determine the expected volatility of the common stock, The Value Line Investment Survey calculates the historical volatility over a five-year period. The warrant’s strike price is fairly easy to estimate. An issue’s conversion value and its investment value act as “floors” below which the issue should not trade. Only when an issue’s conversion value is above its investment value, will the warrant portion be adding tangible value to the issue’s price. As a result, the warrant’s strike price can be viewed as the issue’s pershare investment value, which is simply the investment value divided by the number of shares into which the bond converts. In our example, that would be $890/46.296, or approximately $19.22 per share. Assumptions about an issue’s expected time to call are more difficult to estimate because that depends on the company’s management.

Putting It All Together

Because an issue’s time to call is a nebulous factor, determining a convertible’s fair value is tricky, and a calculated guess at best. New convertible investors, for instance, are often tempted to view the warrant value of a convertible as simply a call option until the issue’s time to maturity. Using this line of reasoning, if you plug the numbers used in our example into a standard option model (such as Black-Scholes) and use its maturity date to value the warrant, the indicated fair value would be around $13.75 per share, which would give the appearance that the warrant value is significantly undervalued. However, an issue’s call protection, and the likelihood of a call either because the company can refinance at a lower rate or force conversion into the common, is not taken into account by standard option models.

Value Line’s convertible model, though, is more dynamic and takes into account the various features of the convertible. As a result, our model estimates that the Hasbro 2.75s2021 convertible bond is about 4% overrvalued, which would translate into a fair value of about $1,090.77. At this price level, the fair value of the warrant would be about $4.34 per share, which suggests that the implicit trading price of the warrant of $5.28 is about 22% overvalued.

Summary

Estimating a convertible’s fair value and determining whether it is currently overor under-valued requires careful consideration of all the features of the security, including put and call provisions, which usually go beyond the scope of standard warrant and option pricing models. In general, options and warrants will always have some degree of premium over tangible value so long as there is time remaining to expiration. As expiration approaches, this premium over tangible value decreases, reflecting the loss of time value (or “decay”). In the case of convertibles, however, when an issue’s call protection expires, if the conversion value exceeds the call price and a call appears likely, it is not uncommon for convertible bonds to trade below conversion value (reflecting the potential loss of accrued interest) in anticipation of a redemption call. Value Line’s convertible evaluation model is dynamic in that it considers these various scenarios in valuing each issue.s