Intelligent Investor Chapter 16 Summary: Convertible Issues and Warrants

Convertible Issues and Warrants

  • Convertibles are sold with a conversion ratio. If a bond of 1K is sold at 25 conversion ratio and stock price at that time is 40, if stock price rises to 60 - his claim to 25 shares is now worth 1.5K.
  • Convertibles are claimed to be advantageous to investor and issuer - protections of bond/preferred stock, opportunity in benefit of rise in common stock for investor and ability to raise capital at moderate interest and in case of profits, can get rid of senior obligation by exchanging into common stock. But in exchange for the conversion privilege, investor need to give up on quality/yield(in a bear market,they perform better than stocks, but worse than medium and long term bonds). Issuer has to give up on part of common shareholders' claim to future profits.
  • Convertibles floated in the latter part of bull market tend to give unsatisfactory results as the stock prices have already been realized.
  • Some convertibles with short term maturities, attractive common stock, low price and call protection are better.
  • A bond is called when issuer forcibly pays it off before maturity.
  • As stock prices raise, buyer gets into a dilemma if he should sell/hold. When stock prices raise, issuer can call the bond before it gets converted.By converting early, you may lose claim to interest and any chance of profits. This inevitably turns buyer into a speculator.
  • AT&T which issued such convertibles profited buyers, which is because of the soundness of the company itself rather than the convertibles.
  • Effect on common stock: Leads to pro forma increase in earnings. Dilution factor should be considered to get an adjusted EPS if all convertibles are converted.
  • Switch from common to preferred stocks: Seems okay.
  • Stock option warrants: Misleading and no way beneficial to anyone. Common stock holders lose part of their rights when stock option warrants are issued. Inflates price.

Commentary:

  • Convertibles behave like stocks and work like options.
  • Pays low interests.
  • Stocks for chickens: For an all bond holder, diversified convertibles will provide a chance of profitability with lesser risk than stocks.
  • In case of bankruptcy, they don't have a prior claim.
  • Major market of convertibles is held in hedge funds.
  • Expensive to trade small lots of convertible bonds - low cost convertible bond fund is better.
  • Call options: You bought 100 shares each of 95, you can sell/write a call option on your shares. In exchange, you get a call premium(say 10 per share). Buyer now will have a contractual right to buy your shares at a mutually agreed upon price, say 100. So if stock goes beyond 100, you lose your shares. Only broker benefits. 
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See Intelligent Investor Summary for other chapters summary.

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