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  • elec11235 elec11235 Jul 17, 2013 4:33 PM Flag

    Convertible Dilution (and Anti-Dilution Provisions)

    I was thinking a little about what an anti-dilution provision on a convertible might look like. And about what the short position might look like for the convertible buyer. Some thoughts (with round numbers to illustrate):

    Suppose the company wanted to sell $100 million of a 5-year convertible note at a $7.50 share price, with a 3.00% coupon. The total shares they'd convert to is 13.33 million.

    Further, suppose the company wanted to buy an option to buy back those shares at $7.50. They're buying a call option and the bond buyer is writing a call option. If the company pays upfront 20% of the strike price of $7.50 ($1.50) for the option, that brings the bond buyer's net investment to $80 million. Maybe a good way to think about it is like an original issue discount. It brings the bond buyer's annualized return (assuming the bond is repaid in full) to approximately 8.00% (vs 3.00% in the base assumption). This is because the $3 million coupon is more like a 3.75% yield on a net investment of $80 million, and because the buyer gets $100 million back at maturity.

    The question is now what such a bond-buyer's motivation is to short. On the one hand, taking a 13.33 million share short position is effective insurance against a default. The cost of carrying the position might be viewed as premium on a credit-default swap.

    But, in such a scenario, if everything goes well and the company repays the debt, converts to 13.33 million which they then buy back at $7.50 (effectively making the convertible look a lot more like a regular, higher-priced cash bond)... how does the bond buyer close the short position?? This is the part I'm stuck on.

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    • Leaving aside the whole using shorts as hedge vs default thing for now,

      What's the difference between your idea - holding a convertible bond + short call options at the same strike (presumably European options?) vs just holding a plain old bond?
      It seems they simply cancel out.

      In other words a convertible bond like a combination of a regular bond and a call option. write an identical call option and you're left with just the bond.

      • 1 Reply to l_yoni
      • I think that's exactly right. But the convertible bond gets the embedded call "for free." So, turning around and selling those rights back are just like getting a discount on the initial bond purchase (i.e. juicing the bond yields).

        Not sure why someone would prefer to do this over just taking a higher-yield bond. That's why I think the convert + short position makes sense. I'm just not sure where the call option that gets sold to GTAT fits in without leaving a net long (or short) position.