Bonds With Warrants and Embedded Options

Prepared By:Mr. Japan Shah,

Founder & MD- JMS ADVISORY SERVICES PRIVATE LIMITED

• 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

Bonds…

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• 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 portfoilio the risk of the portfolio also reduces.

Who can invest…

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• 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

Terminology in Bonds

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• 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

Types of Bonds

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• 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

Returns From Bonds

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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

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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…

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