Bonds With Warrants and Embedded Options

Prepared By: Mr. Japan Shah B.Com, LL.B, MBA, CS Inter

Bonds
An investment tool for the investor A tool to source funds for the corporate/ government It can be described as a investment vehicle which has very less risk with stable returns.. The interest paid on the bonds by the corporate is a tax deductible expenditure, so the companies can offer better rate of return
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Who can invest

The investors with the objective of stable returns with less risk The investors risk return profile to be studied well The investment in the government securities has 0% default risk.. By including the BONDS in the portfolio the risk of the portfolio also reduces.
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Terminology in Bonds
Face Value Coupon Rate Maturity date & Maturity Redemption Premium Call Option- BUY OPTION TO ISSUER Put Option- SELL OPTION TO INVESTOR Bond Price Basis points
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Types of Bonds
Secured (Mortgaged) v/s Unsecured Bonds (Straight) Senior v/s Subordinate Bonds Registered and Unregistered Bonds Convertible and Non-Convertible Bonds Zero Interest Convertible Debentures Detachable Equity Coupons/ Warrants Secured Premium Notes Triple Option Convertible Debentures Auction Rated Debentures Third Party Convertible Debentures Floating Rate Bonds Floating Rate v/s Fixed Rate Bonds Bonds/ Mr. Japan Shah

Returns From Bonds

Interest Payments i.e. coupon rates Capital Gain/ Loss arising out of sale of bond Cash realization on sale of Bond Redemption by the Issuer on the said date Interest and the CG are the returns to the Bond Holder, wherein the Other 2 are principal amount of the investor The return depends on whether the Investor holds the bond upto MATURITY or redeems it before MATURITY
Bonds/ Mr. Japan Shah

Bonds With Warrants

The bonds have warrants attached which can be converted into shares This kind of bonds are issued by the companies who are offering less return on bonds The investors are attracted by these bonds

Bonds/ Mr. Japan Shah

Characteristics of Warrants
Investors decide the call/ put option whereas the corporate issue warrants Warrants have a longer shelf life (5-10 years) whereas CALL/PUT option have smaller shelf life Each warrant is different/ unique Warrants are more traded in secondary markets
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Value of a Warrant
The market price of the warrants fluctuates between the minimum and the maximum limit The minimum Value = (Ps-Pe)* N Where Ps is the current market price, Pe is the exercise price and N is the number of shares The minimum value of the warrant is called the INTRINSIC VALUE
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Warrant Premium
The difference between the warrant price and the minimum value of the warrant is called the WARRANT PREMIUM The exercise price depends on the expiration period, variability in the stock price and the leverage provided by the warrant. The value of the change in the price of the stock and the price of the warrant is called STOCK WARRANT RATIO Warrants are expiring assets and their value decreases with the nearing the maturity Minimum value of the warrant should not exceed the market price of the common stock

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Factors Determining the Premium on Warrants

Maturity Period of Warrants-Premium Increases Price Volatility of Shares-Increases/ Decreases Dividend on the Stock-Decreases Potential leverage on the Warrant- Increase/ Decrease

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Value of a Warrant
Value per Share= Vt + MKX -------------N + MK Where Vt is the value of Equity before the warrants are exercised, N is no. of shares held presently , M is no of warrants issued, K is no of shares attached to each warrant, X is the exercise price
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Advantages to Company
Well established companies with good track record can issue such bonds, to attract investors with less dependence on banks, financial institutions and mutual funds The company can increase the capital by issuing the bonds The overall cost of the debt fund is less in bonds as the investor will accept less yield with the warrants
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Advantages to Investor
The investors get an option to get the equity with the bonds There is a good growth in capital along with stable regular returns There is good leverage offered to the investor, the investor can sell the warrants in the market The warrants are listed and traded independently and so there is also enough liquidity The risk is very limited and rewards can be very high Also the one with speculative interest can invest in such kind of bonds
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Types of Warrants
Detachable Warrants Puttable Warrants Wedding Warrants Naked Warrants

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Convertible Bonds
These are the kinds of bonds which can be converted into a predetermined number of shares after a predetermined period of time The number of shares the investors will receive is called the conversion ratio The price at which the bond is exchanged with the share is called the conversion price They have call/ put options Hard Put means are converted into CASH only, soft put means can be converted into any security
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 Downside Risk of Investment in Convertible Bonds Characteristics of Investing in Convertible Bonds Value of Conversion Benefits--- PREMIUM

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Market Values- Premium

When the market price exceeds the conversion price, the value is called PREMIUM Conversion Premium= Market Price-Conversion Value X 100 ----------------------------------------Conversion Value Premium over Conversion Value= BP-CV/CV Premium Over Investment Value= BP-IV/BP BP= Bond Price, CV= Conversion Value, IV= Investment Value
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 Conversion Parity Price= Bond Price ---------------No. of Shares on Conversion per Warrant Break Even Point= Conversion Premium -----------------------------Interest Income- Dividends
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Callable Bonds- Components

Two transactions take place in these kind of bonds.. A. Purchase of Non-Callable Bond B. Sale of Call option Price of Callable Bond= Price of Non-Called Bond Price of Call option

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Puttable Bonds- Components

A. Purchase of Non-Puttable Bonds B. Purchase of Put option on the Bond Price of Puttable Bond= Price of Non-Puttable Bond + Price of Put Option

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Floating rate Notes (FRNs)

A Floating Rate Note is a bond which is issued for a medium to long term, which pays coupon that are pledged to the level of a certain floating index, which is called reference index

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Features of FRNs
Reference Index Quoted Margin to reference Rate Reset Frequency Observation Date Maturity Date
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Types of FRNs
Flip- Flop FRN- Fixed & Floating Mismatch FRN-Rolling Rates FRN Mini-Max FRN-Minimum & Maximum Coupon is Predetermined Capped FRN-Interest Rate Cap, celling rate Structured FRN- Variable Rate FRNs Perpetual FRN- Irredeemable FRNs Deleveraged FRN-Reference is not taken Full Inverse FRN- Vice Versa Impact of Interest Rates
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Other Features of FRNs

Call Feature Put Feature Cap Feature Floor Feature Collar Feature
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Risks in FRNs
Interest Rate Risk

Default Risk

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Valuation of FRNs
Current Interest Annuity Stream Par Bond

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Modern Forms of Bonds

Dual Currency Bonds Equity Index Linked Notes Commodity Linked Bull and Bear Bonds Swap Linked Bonds

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Thank You