Other Asset Classes

Question 1

What factors make debt more attracitve?

Answer 1

• Liquidity - the larger the issue the greater the liqudity.
• Ability to extend - option to extend is favourable if interest rates from now are lower than todays interest rates. In contrast if interest rates increase, the investor can present the bond for payment and reinvest the money for a higher return.
• Senior claim - Debentures are backed only by the general creditworthiness and repuation of the issuer.
• Call Features - makes bonds more attractive as gives an equity option.
• Sinking fund - Requires issuer to retire part ofthe issue each year. Since most sinking funds give the firm the option to retire this amount at the lower of par or market value, the sinking fund can be detrimental for bondholders.
• Maturity - longer the maturity the higher the coupons.

Question 2

What are convertible bonds and what determines the premium?

Answer 2

• Convertible bonds enable the holder to exploit the upside potential of equity whilst retaining the safety of the bond. Investors can expect to pay a premium for instruments that offer equity growth potential but without the equity downside.
• Premium:
  
  • The premium suggests that investors value to option highly and it will depend on:
    
    • Time value - longer the better
    • If the stock is expected to perform
    • underlying stock is intrinsically valuable due to low probability default and high credit rating.

Question 3

What is the conversion value on a convertible bond?

Answer 3

• Conversion value = conversion ratio x stock price
• Option premium = convertible bond issue - conversion value
• Premium as a % of the conversion value
• Conversion value for $100 nominal is 25 * 3.80 = $95.
• The bond is trading at $120 so the premium is currently $120 - $95 = $25
• Premium as a % of the conversion value is 25/95 = 26.3%.

Question 4

Why do companies issue convertible bonds?

Answer 4

• Lower debt capital financing costs becuase their future equity is attractive.
• Management try to signal that the company’s prospects are more postive that the market believes.
• Companies who do not want immediate earnings dilution. If the equity price dose ris above conversion than earnings are likely to have risen also, which is more palatable to dilution averse shareholders. If stock is from Treasry then no dilution, plus debt is exstingshed so the balance sheet is altered.
• Companies who want to keeep control on the rapid growth period but happy to give this up in the future.
• If growth prospects fulfilled the debt will not need to be paid back.
• Conversion rights help the company to issue unsecured debt without prohibiting coupon and servicing costs.
• Company that wishes greater alignment of interest between bondholders and shareholders concerning the risk taking of the company.

Question 5

What are the differences between warrants and convertibles?

Answer 5

• Warrants:
  
  • A warrant gives the holder the opportunity to purchase a pre-determined number of shares at a pre-determined price at some point in the future.
  • Warrants are usually issued by investment trusts or by companies.
  • Often issued as an equity sweetner.
  • CGT is payable on disposal of an exercised warrant.
  • Exercise of warrant requires the firm to issue new shares, making the warrant dilutive.
  • Warrants also result in cash flow to the firm when the warrant holder pays the exercise price.
  • A covered equity warrant is really a long-dated call option over shares and issued by a third pary with a holding of the shares of the company is question, so that when an investor exercies the warrant, he or she will receive shares that already exist.
  • Warrant terms may be tailored to meet the needs of the firm.
  • Warrants are protected against stock splits and dividends, in that the number of warrants held are adjusted to offset the effects of the split.
• Convertible bonds:
  
  • Link two different assets whereas a warrant links just one.
  • Convertible is fixed number of shares regardless of the market price.
  • Conversion is available at certain times during the convertible security lifes, usually at the discretion of the bondholders.
  • The convertible will have value even if the bond remains unconverted.
  • The issuer sets a conversion ratio so that conversion will not be profitable unless there is a substantial increase in stock price. Convertible bonds are usually issued deep out of the money.
  • Convertibles rank higher than common shares that warrants are usually linked to.

Question 6

What are the impacts of including alternative assets in a portfolio?

Answer 6

• Expected return - More risky than conventional asset classes due to fewer pricing points, lower liquidity, uncertain distributuions and indivisibily. Given a trade-off between risk and required return alternative assets should have a higher expected return. Examples such as infrasturcutre offering higher yields.
• Diversifcation - An unconstrained portfolio optimisation will often allocate much greater weight to alternative asset classes than fund managers would consider practicalbe. PE might be less diversifed and commodites are often linked to the economic cycle.
• Risk - very in their exposure to inflation, leverage, failure rates, manager selection risk, moral hazard and agency risk.
• Liquidity - Often less liquid and may have fewer pricing points. Volumes can oftern be small, so the desire to buy and sell may signifcantly move prices against trading positions.
• Divisibility - can be lumpy and indivisble and lead to large lot sizes. For small and medium size investors this can prevent small exposures to the assets and make any exposure gained a risk in terms of the overall portfolio allocation to this asset.
• Transaction costs - High legal costs for PE, high search costs for funds, storage costs for commodities.