Simple and Lucid understanding of Bonds and Bonds with warrants

1. Bonds With Warrants and
Embedded Options
Prepared By:
Mr. Japan Shah,
Founder & MD- JMS ADVISORY
SERVICES PRIVATE LIMITED

2. Bonds…
• 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
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3. Who can invest…
• 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.
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4. Terminology in Bonds
• 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
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5. Types of Bonds
• 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
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6. Returns From Bonds
• 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
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7. 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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8. 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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9. 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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10. 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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11. 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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12. 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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13. 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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14. 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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15. Types of Warrants
• Detachable Warrants
• Puttable Warrants
• Wedding Warrants
• Naked Warrants
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16. 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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17. • Downside Risk of Investment in Convertible
Bonds
• Characteristics of Investing in Convertible
Bonds
• Value of Conversion Benefits--- PREMIUM
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18. 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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19. • Conversion Parity Price=
Bond Price
----------------
No. of Shares on Conversion per Warrant
• Break Even Point=
Conversion Premium
------------------------------
Interest Income- Dividends
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20. 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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21. 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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22. 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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23. Features of FRNs
Reference Index
Quoted Margin to reference Rate
Reset Frequency
Observation Date
Maturity Date
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24. 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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25. Other Features of FRNs
Call Feature
Put Feature
Cap Feature
Floor Feature
Collar Feature
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26. Risks in FRNs
Interest
Rate
Risk
Default
Risk
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27. Valuation of FRNs
• Current Interest
• Annuity Stream
• Par Bond
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28. Modern Forms of Bonds
Dual Currency Bonds
Equity Index Linked Notes
Commodity –Linked Bull and Bear Bonds
Swap –Linked Bonds
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29. Thank You…
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