Controversial Convertibles
What is a bank led exchangeable and why is it controversial?
The trading desk of a bank monetizes a stake through an equity-linked security.
Potential issues: The complexity of these bonds can obscure the bank’s real intentions, like exiting a risky position, leaving investors unaware of the full risks involved. There could be a conflict of interest. Banks may quietly exit a strategic investment using these bonds, which can harm long-term investors or signal a lack of confidence in the reference company.
What Regulation allows call spread to be non-GAAPed?
Regulation G requires that any public disclosure or release of non-GAAP financial measures must include:
Item 10(e) of Regulation S-K provides additional requirements for the use of non-GAAP financial measures in filings with the SEC, including:
What are the first names of the Baker Brothers?
Julian & Felix
First ever convertible you did? Terms / Size / ABR Syndicate
First buzzer to answer
Do holders have the ability to early convert on a mandatory convertible preferred?
Yes, at min ratio
What is a rubl-linked convertible bond? Why would a company do it?
Allows companies to raise foreign capital while managing foreign exchange exposure. Ruble-linked convertibles allow investors to convert their bonds into shares of the issuing company at a future date or under certain conditions. The key difference is that the conversion price or value may be adjusted based on the exchange rate between the ruble and another currency, typically the U.S. dollar or euro.
Is there MTM on an exchangeable bond to a non-consolidated subsidiary?
Yes. Exchangeable bond linked to non-consolidated sub (i.e. <50%) is mtm derivative in its entirety or bifurcated as debt host + mtm derivative (issuer upfront choice)
PM of DE Shaw & PM of Polar Capital
Harry Chiel & Steve McCormick
Which of the Mag 7 have issued a convertible bond?
Tesla; Yes; Issued convertible bonds in 2013 and 2017 to raise capital for expansion.
Apple; Yes; Issued convertible bonds in 2013 as part of a $17 billion bond offering.
Amazon; Yes ; Issued convertible bonds in 2000 to help fund its early growth.
Meta (Facebook) No No major issuance of convertible bonds in public markets.
Nvidia; No
Microsoft; No
Alphabet (Google); No
What is the difference between an exchange agreement and a subscription agreement?
An exchange agreement is used to facilitate the exchange of assets between parties. A subscription agreement is used to facilitate the purchase of securities, such as stocks or bonds, by an investor. It outlines the terms under which the investor agrees to buy the securities.
Convert with largest F/O that has been publically marketed as per database?
Desktop metal - 2022 - 61.1%
How is a mandatory exchangeable bond accounted for on the balance sheet?
Example: A company issues $100 million in mandatory exchangeable bonds, requiring the exchange into shares of Company X in five years. The present value of the debt (coupon payments) is $90 million, and the value of the exchange option (derivative) is $10 million.
Assets:
Cash: +$100 million (reflecting the proceeds from the bond issuance).
Liabilities:
Debt (Liability component of MEB): +$90 million (representing the present value of future coupon payments).
Derivative Liability (if applicable): +$10 million (representing the value of the exchange feature as a derivative).
Key Point: The exchangeable feature (if classified as a derivative) is recorded as a derivative liability and remeasured at fair value each period. If the conversion is fixed, this might be treated as equity.
What is a convertible investor cost-of-carry? Which type of investor does it apply to?
Coupon + Short rebate - margin interest;
1. Context of Short Selling
In a short sale, an investor borrows shares of a stock, sells them immediately, and aims to buy them back later at a lower price to return to the lender, profiting from the price difference.
The borrowed shares come from another investor's account, typically facilitated by a broker.
2. Short Sale Proceeds and Lending Fee
The proceeds from the short sale are held by the lender (the brokerage firm or prime broker), who may invest them and earn interest.
A portion of this interest earned is then rebated back to the borrower (short seller), which is known as the short rebate.
Nominate the convertible deal of the year / why?
Subjective
What is a screw clause? And how does FV change (all else equal) if the box gets checked or unchecked in KYNEX?
A screw clause is a contractual provision in a convertible bond's indenture agreement that prevents the bondholder from receiving interest that has accrued since the last coupon date when the bond is converted. This can reduce the incentive for conversion.
Here are some ways a screw clause can work:
The screw clause can reduce the fair value of a convertible bond by reducing the incentive to convert
What was the size of the SVB marketed mandatory convertible? How was it structured? Why did it inevitably fail?
$500 million of depositary shares, with each depositary share representing a 1/20th interest in a share of the Series F Mandatory Convertible Preferred Stock. Each share of the preferred stock had a liquidation preference of $1,000, equating to $50 per depositary share SVB’s financial troubles began with a significant loss from the sale of its available-for-sale securities portfolio, amounting to a $1.8 billion after-tax loss. This was part of a broader liquidity crisis triggered by the mismatch between SVB's long-term investments in bonds (which lost value due to rising interest rates) and the need for liquidity as depositors withdrew funds rapidly.
As interest rates increased, SVB’s bond portfolio depreciated, and the bank’s balance sheet became increasingly strained, leading to a significant liquidity crunch
What is MTM wrt to convertible bonds?
When a company issues a convertible bond, the conversion option (the right of bondholders to convert the bond into equity) may be treated as a derivative if it contains certain features, such as a variable conversion price.
Under accounting standards like U.S. GAAP (ASC 815) and IFRS (IFRS 9), if the conversion feature is classified as an embedded derivative, it needs to be revalued at fair value each reporting period.
The mark-to-market process involves calculating the fair value of the conversion feature based on factors like stock price, interest rates, and volatility.
2. Impact on P&L (Profit and Loss) Statement:
Any changes in the fair value of the embedded derivative are recorded in the income statement (P&L) as a gain or loss.
If the value of the conversion feature increases (due to a rise in the stock price or increased volatility), the company will record a loss in the P&L because the bondholders' conversion right becomes more valuable.
Conversely, if the value of the conversion feature decreases, the company will record a gain, as the liability associated with the conversion option declines.
3. Drivers of MTM Gains and Losses:
Stock Price: An increase in the underlying stock price raises the value of the conversion option, leading to MTM losses.
Volatility: Higher stock price volatility increases the value of the conversion feature, resulting in a higher MTM liability and a loss on the P&L.
Interest Rates: Changes in interest rates can also impact the fair value of the bond and the embedded option.
What is implied volatility and name 2 strategies they could deploy?
Implied volatility is the volatility required for the theoretical price of the option to equal the market price. It can be thought of as the volatility implied by the market price.
Convertible Arbitrage
Convertible arbitrage is one of the most popular strategies in the hedge fund space. In this strategy, investors buy the convertible bond and short the underlying stock. The goal is to profit from the bond’s fixed-income payments while taking advantage of potential mispricing between the bond and the stock.
Implied volatility plays a key role because the embedded option within the convertible bond becomes more valuable with higher volatility. Hedge fund investors analyze whether implied volatility is priced correctly. If they believe it is underpriced compared to historical or expected future volatility, they will buy the bond and hedge the equity risk by shorting the stock.
The hedge ratio (or delta) depends on the bond's implied volatility. Higher volatility increases the likelihood of conversion, and hedge funds adjust their stock shorts accordingly. This strategy is particularly effective when implied volatility is expected to increase.
2. Volatility Arbitrage
Hedge funds often trade on the difference between implied volatility and realized volatility. If the market's implied volatility is lower than what the hedge fund expects the stock’s future volatility to be, they may buy the convertible bond, betting that volatility will increase, making the conversion option more valuable.
Conversely, if implied volatility is high and the fund believes actual stock price movements will be lower than expected, they may short the convertible bond or reduce their bond position, locking in gains before volatility declines.
3. Gamma Scalping
Gamma measures the rate of change of delta in response to price movements. Convertible bonds exhibit significant gamma because of the embedded equity option. When implied volatility is high, convertible bonds have more sensitivity to stock price movements (i.e., their delta changes rapidly).
Hedge funds can take advantage of short-term fluctuations in stock prices by constantly adjusting their short position to capitalize on the changing delta. This strategy is known as gamma scalping—hedging in small increments as the underlying stock moves. When implied volatility rises, the bond becomes more sensitive, allowing hedge funds to profit from these adjustments.
4. Delta Neutral Hedging
Delta neutral is a strategy where hedge funds hold a position in the convertible bond and a corresponding short position in the underlying stock, such that the portfolio’s overall exposure to stock price movements is neutralized (delta is close to zero). This allows them to focus on profiting from changes in implied volatility and the bond’s credit spread rather than the stock price.
If the implied volatility rises after the position is established, the value of the convertible bond’s embedded option increases, allowing the hedge fund to profit even if the stock price does not move significantly.
5. Skew Trading
Hedge funds may also engage in skew trading, which involves exploiting the difference in volatility between different strike prices or maturities of options on the same underlying stock. In the context of convertibles, hedge funds might look at the implied volatility of the bond’s conversion feature and compare it to the implied volatility of the stock’s listed options.
If they find that the convertible bond’s implied volatility is underpriced relative to the stock’s options, they may go long on the bond and hedge their risk with equity options, capturing the volatility mispricing.
6. Vega Trading
Vega measures the sensitivity of the convertible bond’s price to changes in implied volatility. Hedge funds use vega trading strategies when they expect significant changes in volatility. If they expect implied volatility to increase, they buy convertible bonds with a high vega because these bonds will increase in value as volatility rises. Conversely, if they expect volatility to decrease, they might short bonds with high vega.
7. Credit Spread and Volatility Interaction
Convertible bond traders also look at the interaction between credit spreads (the difference in yield between the convertible bond and risk-free debt) and implied volatility. If implied volatility rises while credit spreads remain tight, the bond may become more attractive due to the increased value of the embedded option.
Hedge funds might focus on convertible bonds with high implied volatility and low credit risk, where they can capture gains from rising volatility without taking on significant credit risk. Conversely, in situations of high credit risk but low volatility, they may short the convertible bond and hedge with other instruments.
What is a tokenised convertible bond?
Tokenized bonds leverage blockchain technology to digitize and fractionalize traditional bonds. Each token represents a portion of the underlying bond, allowing investors to buy and trade fractions of bonds instead of entire units.
Example:
Issuer: Credit Suisse
Date: March 2019
Blockchain: Ethereum
Type: Convertible bond
Purpose: The issuance aimed to demonstrate the feasibility and benefits of using blockchain technology for issuing and trading financial instruments.
Conceptually, what is the main reason why (all else equal) we tend to price exchangeable bonds a higher FV?
Mismatch between issuer and underlyer. i.e. If a convertible is deep in the money, it implies the issuer is doing well. If an exchangeable is deep in the money, it only has a limited indication on the issuer's performance / ability to "be good" for the full exchange value of the notes.
What is a Death Spiral Convertible bond? Why companies issue it?
In a typical convertible bond, the conversion price (the price at which the bond can be exchanged for shares) is fixed when the bond is issued. However, in a death spiral convertible bond, the conversion price is tied to the current market price of the stock, typically with a discount. This means that as the stock price falls, the bondholder can convert the bond into more shares.
For example, imagine a company issues a death spiral convertible bond with a 20% discount to the market price. If the stock is trading at $10, the bondholder can convert the bond into shares at $8 per share. If the stock price drops to $5, the bondholder can now convert at $4 per share, receiving more shares for the same bond. Companies typically resort to issuing death spiral convertibles when they are in financial distress and cannot access traditional capital markets. These bonds offer a quick infusion of cash because the bondholders expect to profit from conversion even if the stock falls. However, the downside for the company is that it sets the stage for a massive dilution of shares if the stock price starts to decline. Global Crossing: This telecom company is a classic example of a firm that issued death spiral convertibles in the early 2000s. As the company’s stock price fell, bondholders converted at increasingly lower prices, diluting shares and exacerbating the company’s stock price collapse. Global Crossing eventually filed for bankruptcy.
Xerox: In the late 1990s, Xerox issued death spiral convertibles, and as the company faced financial difficulties, its stock plummeted. Bondholders converted at lower and lower prices, diluting the existing shareholders and contributing to a steep decline in the stock price.
If you raised a $100mm convertible with tax-integrated capped call (10% cost), assuming a 20% tax rate what is the DTA that’s created?
Brian to provide answer
Name A-K convertible investors and if LO / HF?
Advent Capital Management; Long-Only
AQR Capital Management; Type: Hedge Fund
BlueMountain Capital Management; Type: Hedge Fund
BlackRock; Type: Long-Only
Citadel LLC; Type: Hedge Fund
Calamos Investments; Type: Long-Only
DE Shaw & Co.; Type: Hedge Fund;
DoubleLine Capital; Type: Long-Only
Elliott Management; Type: Hedge Fund
Eaton Vance; Type: Long-Only
Fortress Investment Group; Type: Hedge Fund
Fidelity Investments; Type: Long-Only
GLG Partners (Man Group); Type: Hedge Fund
Guggenheim Partners; Type: Long-Only
Highbridge Capital Management; Type: Hedge Fund
Harbor Capital Advisors; Type: Long-Only
Icahn Enterprises (Carl Icahn); Type: Hedge Fund
Invesco; Type: Long-Only
JPMorgan Asset Management; Type: Long-Only
King Street Capital Management; Type: Hedge Fund
K2 Advisors (Franklin Templeton); Type: Long-Only and Hedge Fund
Who & when was the first US issuer of the convertible bond?
Chicago, Burlington & Quincy Railroad
Mid 19th Century (1850s or 1860s) – during the height of the railroad expansion in the USA
Explain the short position in the context of a greenshoe
Initial Short Position: During the convertible bond offering, underwriters may sell more bonds than the company initially planned to offer. This creates a short position because the underwriters are selling bonds they do not yet own.
Stabilization Mechanism: The short position allows underwriters to stabilize the bond's price in the secondary market. If the bond's price falls below the offering price, underwriters can buy back bonds in the open market to cover their short position. This buying activity can help support the bond's price.
Exercising the Greenshoe Option: If the bond's price remains stable or rises, indicating strong demand, the underwriters can exercise the greenshoe option to purchase additional bonds from the issuer at the offering price. These bonds are then used to cover the short position created by the over-allotment.
Example Scenario: