Convertible Bond Asset Swaps

1
Convertible Bond Asset Swaps

• Gitanjali Pundir
• Anthony Robinson
• Jason VillanoDennis Young
• April 9, 2002

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Presentation Agenda

• Review the convertible bond market, recent trends
  and the environment for asset swaps
• Discuss the structure of asset swaps and
  convertible bond asset swaps
• Explore the objectives of the key investors in
  this market
• Provide a practical example of a convertible bond
  asset swap

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Advantages of Convertible Bonds

• From issuers perspective, the embedded equity
  option gives coupon rates 300-400 bps below
  straight debt coupon
• Embedded option typically struck 25-25 above
  stock price at time of issuance
• Convertibles usually trade at a premium to their
  intrinsic value or parity

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Simplified Convertible


Bond
Warrant
Convertible

• Relative to common stock, convertibles offer
• Higher Current Yield
• Greater Downside Protection
• Seniority over common stock in income payments
• And liquidation

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Trends in the Convertible Market

• Credit quality of convertible bond issuers has
  been improving
• Larger companies coming to market with large
  issuance, more frequent put dates
• Much higher investment grade zero coupon
  convertible issuance despite declining volatility
• Exploitation of tax and accounting advantages
  using zero coupon convertibles

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Structure
Bond PX Option Value
Convert Arb Fund
Merrill Lynch
LIBOR spread
YTM Option
Bond PX Option Value
LIBOR Spread
Convertible Bond
Fixed Income Investor
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CB Asset swapping

• A way to extract or isolate the credit risk in
  the convert
• Repackage the fixed income component of the CB
  into a synthetic floating rate asset
• Most of time, the spread is much more attractive
  than those in the straight debt market

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CB Asset swapping

• Equity Investor sells bond at the bond floor,
  which equals the bond price the equity option
  value
• Fixed Income Investor buys at the bond floor
• Bank pays LIBORcredit spread
• Fixed Income Investor pays bond coupons

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The Equity Investor

• Convertible Arb Funds and Hedge Funds using
  convert asset swaps with more frequency.
• Cheaper Equity exposure through converts than the
  listed option market. Converts equity option
  have lower implied volatilities.
• Much better hedge than default protection.
• Increased leverage through the asset swap versus
  buying the bond and buying default protection.

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Increased Leverage Example

• Buy convert and buy default
• Bond Price 100
• Net Payout 100
• Buy convert sell bond into asset swap
• Bond Price 100
• Equity Option Value 30
• Bond floor and Proceeds from sale 70
• Net Payout 30

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The Fixed Income Investor

• Typically banks and insurance companies
• Asset swap provides significant yield pickup
  versus straight debt
• Asset swap directly isolates the credit risk of
  the issuer
• Investor has access to names that do not issue
  straight but only convertibles
• Must deal with credit exposure to the company and
  the call risks

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Finding Cheap Volatility Yield Pickup

• Look at relative value between a convertible and
  a benchmark straight bond from the same issuer.
• The best fit straight bond is usually pari passu
  and has a similar maturity.
• Use Option Adjusted Spread analysis to compare
  these two bonds on a yield spread basis.
• Find the theoretical option adjusted spread given
  the stock implied volatility in the listed
  options market.
• This OAS is the theoretical spread that a swap
  dealer could offer the fixed income investor via
  an asset swap.
• This spread usually provides significant yield
  pickup to the straight bond.

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Carnival Cruise Line Convertible Bond
ExampleCarnival Straight Debt Trading at LIBOR
125
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Carnival Cruise Line Convertible Bond
ExampleCarnival Straight Debt Trading at LIBOR
125