TOPIC 2.2: CONVERTIBLE SECURITIES Reading: Analyzing Convertible Bonds

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EXAMPLE: Convertible bond values Kathleen Sullivan purchased a convertible bond of GetGo Corporation a few years ago. The bond has an 8.5% coupon rate, interest is paid semiannually, and the bond matures in six years. Comparable debt yields 9.5% currently. Kathleen’s bond is convertible at $29 a share. The current price of GetGo common stock is $32, and the current price of the convertible bond is $1,226.

What is the investment value of the convertible bond?

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b. 20 shares

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c) $1,200

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b) The extra amount paid for the convertible feature over the bond’s straight value

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a) (Market price - Investment value) / Market price

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c) The greater of its straight value or conversion value

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c) The difference between the bond’s market price and its conversion value

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is the process of selling one debt security (bond) and replacing it with another.

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Bond swapping

The goal of the strategy is to increase the YTM on the bond portfolio, save on income taxes, or reduce the overall interest rate risk of the portfolio.

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involves exchanging one bond for another with similar characteristics but a higher yield.

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substitution swap

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is a strategy where investors exchange bonds from different markets or sectors, believing that the yield difference (spread) between them is temporarily out of line with historical norms or future expectations.

Here’s a simpler explanation:

Imagine you have a government bond, but you notice that corporate bonds are offering much higher yields than usual compared to government bonds. You believe this unusually large difference won’t last long. So, you sell your government bond and buy a corporate bond, hoping to benefit when the yield difference returns to normal.

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An intermarket spread swap

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What is an intermarket spread swap?

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A strategy where investors exchange bonds from different markets (e.g., government for corporate) to capitalize on temporary yield disparities.

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In an intermarket spread swap, what are investors betting on?

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That the yield spread between different types of bonds will return to historical norms or expected levels.

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What is a rate anticipation swap?

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A financial strategy to take advantage of expected changes in interest rates.

It involves swapping different types of bonds based on anticipated movements in interest rates.

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What action is taken when interest rates are expected to increase?

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Long-term bonds are swapped for short-term bonds.

This strategy aims to minimize losses from rising rates.

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What action is taken when interest rates are expected to decline?

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Short-term bonds are swapped for bonds with long maturity dates.

This strategy aims to maximize returns from falling rates.

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Fill in the blank: A rate anticipation swap is used to take advantage of _______ in interest rates.

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expected changes

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True or False: A rate anticipation swap involves only long-term bonds.

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False

It involves swapping both long-term and short-term bonds based on interest rate expectations.

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exchanging a bond with a lower yield to maturity (YTM) for a bond with a higher YTM

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Pure Yield Pickup Swap Basics

This is typically achieved by:

• Selling shorter-maturity bonds
• Purchasing longer-maturity bonds

The goal is to increase the overall yield of the bond portfolio without significantly increasing the risk profile

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This is a strategy known as a Tax Swap