Greatest Care must be taken in Buying Convertible Bonds

Some common popular bonds in the market in recent years are the

• convertible issues and 
• bonds with warrants to buy stock attached.

Convertibles are popular because they seem under certain conditions to combine 

• a degree of bond dollar safety 
• with a chance of profit.

Profits can be made by careful selection, pricing and timing of these bonds.

Market price of convertible bonds

The market price of a convertible bond is a 

• combination of estimated true current investment value
• plus a premium for the current value of conversion privilege, if any.  

This premium varies with 

• the estimated opportunity to make a profit, 
• the length of time the privilege runs and 
• other factors.

The greatest care must be taken in buying convertibles.

The most common mistake is to look too closely into 

• the size of the premium or 
• the closeness of the conversion price on the bond to the current market for the stock into which it can be converted.

You should look first into the stock for which it can be exchanged.

• If you care to make a profit, this must go up.  
• You must start by being fundamentally bullish on the equity.  
• Only then can you look into the mathematical factors governing the price of the convertible bond.

Contingent Convertible Bonds ("CoCos")

CoCos are bonds with contingent write-down provisions.

They differ from traditional convertible bonds in two ways:

• Unlike traditional convertible bonds, which are convertible at the option of the bondholder, CoCos convert automatically upon the occurrence of a pre-specified event.
• Unlike traditional convertible bonds, in which conversion occurs if the issuer's share price increases (i.e. on the upside), contingent write-down provisions are convertible on the downside.

Convertible Bonds

A convertible bond gives the bondholder the right to convert the bond into a pre-specified number of common shares of the issuer.


Why may convertible bonds be attractive to investors?

Convertible bonds are attractive to investors as the conversion (to equity) option allows them to benefit from price appreciation of the issuer's stock.

On the other hand, if there is a decline in the issuer's share price (which causes a decline in the value of the embedded equity conversion/call option), the price of the convertible bond cannot fall below the price of an otherwise identical straight bond.


Why do issuers use convertible bonds rather than straight bonds?

Because of these attractive features, convertible bonds offer a lower yield and sell at higher prices than similar bonds without the conversion option.

Note however, that the coupon rate offered on convertible bonds is usually higher than the dividend yield on the underlying equity.



Some useful vocabulary

• The conversion price is the price per share at which the convertible bond can be converted into shares.
• The conversion ratio refers to the number of common shares that each bond can be converted into.  It is calculated as the par value divided by the conversion price.
• The conversion value is calculated as current share price multiplied by the conversion ratio.
• The conversion premium equals the difference between the convertible bond's price and the conversion value.
• Conversion parity occurs if the conversion value equals the convertible bond's price.

Why issuers often embed a call option alongside the conversion option in the convertible bond?

Although it is common for convertible bonds to reach conversion parity before they mature, bondholders rarely exercise the conversion option, choosing to retain their bonds and receive (higher) coupon payments instead of (lower) dividend payments.

As a result, issuers often embed a call option alongside the conversion option in the convertible bond, making them callable convertible bonds.






An example:   Proposed ICUL of Aeon Credit

http://www.bursamalaysia.com/market/listed-companies/company-announcements/5374537

Summary of proposed ICUL (Convertible Bond) of Aeon Credit

1.  Proposed right issue to raise RM432,000,000, represented by the 432,000,000 ICULS to be issued.

2.  The coupon rate for the ICULS will be a minimum of 3.5% per annum, payable on an annual basis (“ICULS Coupon Rate”).

3.  The ICULS holders can convert their ICULS held into new ACSM Shares anytime from and including the date of issuance of the ICULS (“Issue Date”) up to its maturity date, which is the third (3rd) anniversary of the Issue Date (“Maturity Date”). 

4.  Any ICULS which are not converted would be mandatorily converted into new ACSM Shares on the Maturity Date.

5.  The conversion price for the ICULS has not been fixed.

6.  The Board shall determine the ICULS conversion price, taking into consideration the following: 

(i) the theoretical ex-all price (“TEAP”) per ACSM Share taking into account the Proposals, calculated based on the 5-market day volume weighted average market price (“VWAMP”) up to the date immediately preceding the Price Fixing Date;

(ii) the then prevailing market conditions; and

(iii) the final ICULS Coupon Rate and pricing for rights issue exercises. 

7.  In any event, the ICULS conversion price shall be determined at a minimum of 15.0% discount to the TEAP as calculated in (i) above.

[Comments:

Benefits for the issuer:

• Using ICULS, the company, Aeon Credit, would be able to raise fund by paying a lower coupon rate of 3.5% per annum.  
• The issuer also embed a call option along side the conversion option in the ICULS; any ICULS that are not converted before the Maturity Date would be mandatorily converted into new ACSM shares on the Maturity Date.

Benefits for the investors:

• The company has proposed that the ICULS conversion price shall be determined at a minimum of 155 discount to the TEAP (theoretical ex-all price) as calculated in (i) above.  Thus, the investors benefit by buying with a discount to the prevailing mother share price.
• The investors of the ICULS hope to benefit from price appreciation of the issuer's stock.]

MULTIPLE PROPOSALS AEON CREDIT SERVICE (M) BERHAD ("ACSM" OR THE "COMPANY") I) PROPOSED BONUS ISSUE; AND II) PROPOSED RIGHTS ISSUE (COLLECTIVELY REFERRED TO AS THE "PROPOSALS").

AEON CREDIT SERVICE (M) BERHAD

Type	Announcement
Subject	MULTIPLE PROPOSALS
Description	AEON CREDIT SERVICE (M) BERHAD ("ACSM" OR THE "COMPANY") I) PROPOSED BONUS ISSUE; AND II) PROPOSED RIGHTS ISSUE (COLLECTIVELY REFERRED TO AS THE "PROPOSALS").
On behalf of the Board of Directors of ACSM, CIMB Investment Bank Berhad wishes to announce that the Company proposes to undertake the following: (i)  Proposed bonus issue of 72,000,000 new ordinary shares in ACSM (“Bonus Shares”) at an issue price of RM0.50 each on the basis of 1 bonus share for every 2 existing ACSM ordinary shares (“ACSM Shares”) held (“Proposed Bonus Issue”); and (ii)  Proposed renounceable rights issue of 3-year minimum 3.5% irredeemable convertible unsecured loan stocks (“ICULS”) on the basis of 2 ICULS for every 1 existing ACSM Share held to raise RM432,000,000 in cash (“Proposed Rights Issue”). (collectively referred to as the “Proposals”) Please refer to the attachment for the full text on the announcement of the Proposals. This announcement is dated 23 March 2017. AEON CREDIT SERVICE (M) BERHAD (“ACSM” OR “COMPANY”) (I) PROPOSED BONUS ISSUE OF 72,000,000 NEW ORDINARY SHARES IN ACSM (“BONUS SHARES”) AT AN ISSUE PRICE OF RM0.50 EACH TO BE CAPITALISED FROM THE COMPANY’S RETAINED EARNINGS ON THE BASIS OF 1 BONUS SHARE FOR EVERY 2 EXISTING ACSM ORDINARY SHARES (“ACSM SHARES”) HELD (“PROPOSED BONUS ISSUE”); AND (II) PROPOSED RENOUNCEABLE RIGHTS ISSUE OF 3-YEAR MINIMUM 3.5% IRREDEEMABLE CONVERTIBLE UNSECURED LOAN STOCKS (“ICULS”) ON THE BASIS OF 2 ICULS FOR EVERY 1 EXISTING ACSM SHARE HELD TO RAISE RM432,000,000 IN CASH (“PROPOSED RIGHTS ISSUE”) Proposed Rights Issue 2.2.1 Details The Proposed Rights Issue will be undertaken after the completion of the Proposed Bonus Issue. As mentioned in Section 2.1.1 of this announcement, the Proposed Rights Issue is not conditional upon the Proposed Bonus Issue, and in the event that the Proposed Bonus Issue is not completed for whatsoever reason, subject to obtaining all relevant approvals, the Proposed Rights Issue will be implemented. The Proposed Rights Issue, to be undertaken on a renounceable basis, involves the issuance of 432,000,000 ICULS at 100% of its nominal value of RM1.00 each in cash on the basis of 2 ICULS for every 1 existing ACSM Share held by the Company’s shareholders (“Entitled Shareholders”) whose names appear in ACSM’s ROD as at the close of business on an entitlement date to be determined by the Board and announced later (“ICULS Entitlement Date”) after the completion of the Proposed Bonus Issue. In the event that the Proposed Bonus Issue is not completed for whatsoever reason, the Proposed Rights Issue shall be undertaken on the basis of 3 ICULS for every 1 existing ACSM Share held. The Proposed Rights Issue will raise RM432,000,000 for the Company from the issuance of a total of 432,000,000 ICULS under the Proposed Rights Issue. The Proposed Rights Issue is renounceable in full or in part. This means that the Entitled Shareholders can subscribe for or renounce their entitlements to the ICULS in full or in part. Any ICULS not subscribed or not validly subscribed for shall be made available for excess applications by the Entitled Shareholders or their renouncee(s)/transferee(s).The Board intends to allocate such excess ICULS in a fair and equitable manner on a basis to be determined later by the Board. The ICULS will be provisionally allotted to the Entitled Shareholders on the ICULS Entitlement Date. Any fractional entitlements of ICULS under the Proposed Rights Issue will be disregarded and shall be dealt with in the Board’s absolute discretion in such manner as it deem fits and in the best interests of ACSM. The coupon rate for the ICULS will be a minimum of 3.5% per annum, payable on an annual basis (“ICULS Coupon Rate”). The final ICULS Coupon Rate shall be reflected in the circular to the Company’s shareholders seeking their approval for the Proposed Rights Issue at an extraordinary general meeting to be convened (“EGM”). The ICULS will be constituted by a trust deed to be executed between ACSM and an appointed trustee for the benefit of the ICULS holders. The indicative principal terms and conditions of the ICULS are set out in Appendix I of this announcement. 2.2.2 Basis of determining and justification for the ICULS issue price and ICULS conversion price The ICULS will be issued at its nominal value of RM1.00 each. The nominal value was fixed after taking into account the aggregate proceeds of RM432,000,000 to be raised from the Proposed Rights Issue, represented by the 432,000,000 ICULS to be issued. Due to the timeframe to implement the Proposed Rights Issue and the potential share price movement of the ACSM Shares during this period, the conversion price for the ICULS has not been fixed. The ICULS conversion price will be determined on the price-fixing date to be announced at a later date (“Price Fixing Date”) after receipt of all relevant approvals but prior to the ICULS Entitlement Date. The Board shall determine the ICULS conversion price, taking into consideration the following: (i) the theoretical ex-all price (“TEAP”) per ACSM Share taking into account the Proposals, calculated based on the 5-market day volume weighted average market price (“VWAMP”) up to the date immediately preceding the Price Fixing Date; (ii) the then prevailing market conditions; and (iii) the final ICULS Coupon Rate and pricing for rights issue exercises. In any event, the ICULS conversion price shall be determined at a minimum of 15.0% discount to the TEAP as calculated in (i) above. For illustration purposes only and taking into account the 5-market day VWAMP per ACSM Share up to 22 March 2017, being the market day immediately preceding the date of this announcement of RM16.24 resulting in a TEAP of RM10.48 and assuming a discount to TEAP of 15.0%, the illustrative conversion price of the ICULS is RM8.91 per new ACSM Share after taking into account the completion of the Proposed Bonus Issue (“Illustrative ICULS Conversion Price”). Using the Illustrative ICULS Conversion Price and for illustration purposes only, a total of 48,484,848 new ACSM Shares will be issued upon full conversion of the ICULS. This represents 18.3% of the Company’s enlarged share capital after the completion of the Proposals. 2.2.3 Ranking of the new ACSM Shares arising from the conversion of ICULS The new ACSM Shares to be issued arising from the conversion of the ICULS shall, upon allotment and issuance, rank equally in all respects with the existing ACSM Shares, save and except that they will not be entitled to any dividends, rights, allotments and/or any other distributions that may be declared, made or paid where the entitlement date is before the allotment date of the new ACSM Shares. Based on the terms of the ICULS, the ICULS holders can convert their ICULS held into new ACSM Shares anytime from and including the date of issuance of the ICULS (“Issue Date”) up to its maturity date, which is the third (3rd) anniversary of the Issue Date (“Maturity Date”). Any ICULS which are not converted would be mandatorily converted into new ACSM Shares on the Maturity Date. 2.2.4 Status of ICULS The ICULS shall constitute direct, unconditional, unsecured and unsubordinated obligations of ACSM and subject to the provisions contained in the trust deed, at all times rank equally, without discrimination, preference or priority between themselves and all present and future direct, unconditional, unsecured and unsubordinated debts and obligations of ACSM except those which are preferred by law.

Convertible Preference Shares or Preferred Stock

Preference shares can be classified into the following categories:

• Cumulative
• Non-cumulative
• Participating 
• Non-participating
• Convertible

Convertible Preference Shares

These are convertible into a specified number of common shares based on a conversion ratio that is determined at issuance.

They have the following advantages:

• They allow investors to earn a higher dividend than if they had invested in the company's common shares.
• They offer investors the opportunity to share the profits of the company.
• They allow investors to benefit from a rise in the price of common shares through the conversion option.
• Their price is less volatile than the underlying common shares because their dividend payments are known and more stable.

Convertible preference shares are becoming increasingly common in venture capital and private equity transactions.

Approach to Convertible Issues

An illustration on convertible issue

The fine balance between what is given and what is withheld in a standard-type convertible issue is well illustrated by the extensive use of this type of security in the financing of American Telephone & Telegraph Company.

Since 1913 the company has sold at least seven separate issues of convertible bonds, most of them through subscription rights to stockholders.

The convertible bonds had the important advantage to the company of bringing in a much wider class of buyers than would have been available for a stock offering, since the bonds are popular with many financial institutions which possess huge resources but some of which are not permitted to buy stocks.

The interest return on the bonds has generally been less than half the corresponding dividend yield on the stock - a factor which was calculated to offset the prior claim of the bondholders.

Since the company has been able to maintain its dividend without change for many years, the result has been the eventual conversion of all the older convertible issues into stock.  

Thus the buyers of these convertibles have fared well through the years - but not quite so well as if they had bought the capital stock in the first place.

This example establishes the soundness of American Telephone & Telegraph, but not the intrinsic attractiveness of convertible bonds.

To prove them sound in practice we should need to have a number of instances in which the convertible worked out well even though the common stock proved disappointing.  

Such instances are not easy to find.


$$$$$


Advice by Benjamin Graham on convertibles

Our general attitude toward new convertible issues is thus a mistrustful one.

We mean here, as in other similar observations, that the investor should look more than twice before he buys them.

After such hostile scrutiny he may find some exceptional offerings that are too good to refuse.

The ideal combination, of course, is a strongly secured convertible, exchangeable for a common stock which itself is attractive, and at a price only slightly higher than the current market.  

Every now and then a new offering appears that meets these requirements.

By the nature of the securities markets, however, you are more likely to find such an opportunity in some older issue which has developed into a favorable position rather than in a new flotation.

(If a new issue is a really strong one, it is not likely to have a good conversion privilege.)


Benjamin Graham
The Intelligent Investor

Alternative Investments and Price-Value Relationships

Alternative investments to equities both illustrate the universality of value investing principles and reinforce the key element of relating price to value.  Below summarizes some alternatives to equities and their price-value relationship.

Straight Bonds:  Duration and coupon drive valuation and price.

Convertible Bonds:  Equity component drives variability, some price-value divide.

Real Estate:  Buyers intuit a price-value divide when seeking ":good deals".

Precious Metals:  Supply-demand imbalances drive price-value divide

Other Collectibles:  Personal attachments drive price-value divide


Value investors habitually relate price to value.  This attitude applies not only to equities, but also to all other investments.  The habit of relating price and value comes more naturally for certain assets than others.

Real estate is a good example.  People seem intuitively able to understand that they might be getting a "good deal" on real estate, but many exhibit less intuition when thinking about common stock investments.  They do likewise with consumption goods such as cares and loans or leases taken to finance their purchase.

Markets for some alternatives show how price-value differences are less likely to appear.  Bonds are a good example.  These instruments have features such as duration and interest rate that common stocks lack.  This makes it easier for investors to agree on their value and produces prices more reflective of value.  The absence of these features on common stocks suggests reasons to believe that price-value differences are likely to occur on common stocks.

in·tu·i·tion 

Noun The ability to understand something immediately, without the need for conscious reasoning. A thing that one knows or considers likely from instinctive feeling rather than conscious reasoning.

Synonyms insight - instinct

Rule No. 1: Do Not Lose Money. How Warren Buffett avoids yearly losses in his entire portfolio?

Avoiding losses is probably the most important tool for long-term success in investing. No investor, even Buffett, can avoid periodic losses on individual stocks. Even, if you resigned yourself to buying only at incredibly cheap prices, occasional mistakes will still occur. What differentiates Buffett from nearly all other investors is his ability to avoid yearly losses in his entire portfolio.






How Warren Buffett avoids yearly losses in his entire portfolio?


Warren Buffett would rather not place his faith in the hands of investors and traders. The methods he uses to lock in yearly gains take the market out of the equation.

He reckons that if he can guarantee himself returns, even in poor markets, he will ultimately be way ahead of the game. 
To learn more, we should focus on how Buffett best avoids losses.

These include:

Timing the market. He is not concerned about the day-to-day fluctuations in the stock market. However, Buffett - whether by accident or calculation - must be recognized as one of the most astute market timers in history.

Convertibles. Some of Buffett's most lucrative investments in the late 1980s and early 1990s involved convertibles, which are hybrid securities that possess features of a stock and an income-producing security such as a bond or preferred stock.

Options. On a number of occsions, Buffett has expressed his disdain for derivative securities such as futures and options contracts. Because these securities are bets on shorter-term price movements within a market, they fall under the definition of "gambling" rather than of "investing." If Warren Buffett does dabble in options, and few doubt he could dabble successfully, he does so quietly. He once acknowledged writing put options on Coca-Cola's stock; at the time he was thinking of adding to his stake in the soft-drink company.

#Arbitrage. Not only did Buffett continue to beat the major market averages, but he suffered few single-year declines along the way. That second accomplishment is, by far, the more remarkable. Buffett's scorecard shows that he has increased the book value of Berkshire Hathaway's stock 35 consecutive years. In only 4 years, did the S&P 500 Index beat the growth of Berkshire's equity. Right from the start of his investment management career, Buffett resorted extensively to takeover arbitrage (the trading of securities involved in mergers) to keep his portfolio results positive. In poor market years, arbitrage activities have greatly enhanced Buffett's performance and keep returns positive. In strong markets, Buffett has exploited the profit opportunities of mergers to exceed the returns of the indexes.Benjamin Graham, Buffett's mentor, had made arbitrage one of the keystones of his teachings and money management activities at Graham-Newman between 1926 and 1956. Graham's clients were informed that some of their money would be deployed in shorter term situations to exploit irrational price discrepancies. These situations included reorganizations, liquidations, hedges involving convertible bonds and preferred stocks, and takeovers.


----

There are only 3 ways an investor can attain a long-term, loss-free track record:

1. Buy short-term Treasury bills and bonds and hold them to maturity, thereby locking in 4 to 6 percent average annual gains.

2. Concentrate on private-market investments by buying properties that consistently generate higher profits and that can sell for greater prices each year.

3. Own publicly traded securities and minimise your exposure to price fluctuations by devoting some of the portfolio to unconventional "sure things (arbitrages).# "




Also read:

Focus on how Buffett best avoids losses

http://myinvestingnotes.blogspot.com/2009/09/list-your-top-5-rules-for-success-in.html

Why Hold Cash?

Liquidity brings opportunities.

Do not rush to invest in stocks as soon as you have additional cash available for investing.  Be patient and wait for good investment opportunities.

Holding cash or cash equivalents is not just for safety; it can help you earn more on your investments by enabling you to take advantage of opportunities that arise with brief windows in which to strike.  

From this perspective, keeping some cash or investments in liquid, low-risk securities may prove to be a high-return proposition in the long run.  

In some cases, it might be helpful to invest in convertible preferred stocks or convertible bonds, as long as you stay with established firms the way Buffett does.