In a previous article, we introduced the
CFA Institute Investment Foundation Program (Read
more here). It is a free program
designed for anyone who wants to enter or advance within the investment
management industry, including IT, operations, accounting, administration, and
marketing. Candidates who successfully
pass the online exam earn the CFA Institute Investment Foundations Certificate.
There are total of 20 Chapters in 7
modules, covering all the essential topics in finance, economics, ethics and
regulations. This series of articles
will highlight the core knowledge of each chapter.
Chapter 10 provides an overview of equity
securities. The learning outcome of chapter 10 is as follows:
·
Describe
features of equity securities;
·
Describe
types of equity securities;
·
Compare
risk and return of equity and debt securities;
·
Describe
approaches to valuing common shares;
·
Describe
company actions that affect the company’s shares outstanding.
To raise capital, companies may issue convertible
bonds. A convertible bond is a bond issued by a company that offers the
bondholder the right to convert the bond into a pre-specified number of common
shares. Although a convertible bond is actually a debt security prior to
conversion, the fact that it can be converted to common shares makes its value
somewhat dependant on the price of common shares. Thus, convertible bonds are
known as hybrid securities. Hybrid securities have features of and
relationships with both equity and debt securities.
The number of common shares that the
bondholder will receive from converting the bond is known as the conversion
ratio. The conversion ratio may be constant for the security’s
life, or it may change over time. The conversion value (or parity value) of a
convertible bond is the value of the bond if it is converted to common shares.
The conversion value is equal to the conversion ratio times the share price. At
conversion, the bonds are retired (cease to exist) and common shares are
issued.
Because the conversion feature is a
benefit to the bondholder, a convertible bond typically offers the bondholder a
lower fixed annual coupon rate than that of a comparable bond without a
conversion feature (a straight bond). Convertible bonds have a maturity date.
If the bonds are not converted to common stock prior to maturity, they will be
paid off like any other bond and retired at the maturity date.
When a convertible bond is issued, the
conversion ratio is set so that its value as a straight bond (i.e., the value
of the bond if it were not convertible) is higher than its conversion value. If
the share price of the company significantly increases, the conversion value of
the bond will rise and may become greater than the value of the convertible
bond as a straight bond. If this happens, converting the bond becomes
attractive. In general, if the conversion value is low relative to the straight
bond value, the convertible bond will trade at a price close to its straight
bond value. But if the conversion value is greater than the straight bond value,
the convertible bond will trade at a value closer to its conversion value.
Because a convertible bond should not
trade below its conversion value, bondholders may choose not to convert into
common shares even if the conversion value is higher than the par (principal)
value of the bond. Often, a convertible bond includes a redemption (buyback)
option. The redemption (buyback) option gives the issuing company the right to
buy back (redeem) the convertible bonds, usually at a pre-specified redemption
price and only after a certain amount of time. Convertible bond issues
typically include redemption options so that the issuing company can force
conversion into common shares.
The following example describes a
convertible bond issue of Navistar International Corp. The Navistar bond issue
illustrates the typical features of a convertible bond.
A warrant is an
equity-like security that entitles the holder to buy a pre-specified amount of
common stock of the issuing company at a pre-specified per share price (called
the exercise price or strike price) prior to a pre-specified expiration date. A
company may issue warrants to investors to raise capital or to employees as a
form of compensation. The holders of warrants may choose to exercise the rights
prior to the expiration date. A warrant holder will exercise the right only
when the exercise price is equal to or lower than the price of a common share.
Otherwise, it would be cheaper to buy the stock in the market. When a warrant
holder exercises the right, the company issues the pre-specified number of new
shares and sells them to the warrant holder at the exercise price.
Warrants typically have expiration dates
several years into the future. In some cases, companies may attach warrants to
a bond issue or a preferred stock issue in an effort to make the bond or
preferred stock more attractive. When issued in this manner, warrants are known
as sweeteners because the inclusion of the warrants typically allows the issuer
to offer a lower coupon rate (interest rate) on a bond issue or a lower annual
fixed dividend on a preferred stock issue.
Companies may also issue warrants to
employees as a form of compensation, in which case they are referred to as
employee stock options. When warrants are used as employee compensation, the
goal is to align the objectives of the employees with those of the
shareholders. Many companies compensate their senior management with salaries
and some form of equity-based compensation, which may include employee stock
options.
The following examples describes the use
of warrants to make a deal more attractive to an investor.
A depositary receipt is a
security representing an economic interest in a foreign company that trades
like a common share on a domestic stock exchange. For investors buying shares
of foreign companies, the transaction costs associated with purchasing
depositary receipts are significantly lower than the costs of directly
purchasing the stock on a foreign country’s stock exchange.
Depositary receipts are not issued by
the company and do not raise capital for the company, but rather, they are
issued by financial institutions. Depositary receipts facilitate trading of a
company’s stock in countries other than the country where the company is
located. Depositary receipts are often referred to as global depositary
receipts (GDRs), but may be called by different names in different countries.
In the United States, GDRs are known as American Depositary Receipts (ADRs) or
American depositary shares. Depositary receipts are generally similar globally
but may vary slightly because of different laws.
Now we will consider how depositary
receipts are created and work, using the example of Sony and Mexican investors.
Mexican investors may want to invest in the stock of Sony, a Japanese company,
but Sony’s stock is not listed on the Mexican Stock Exchange. Buying Sony stock
on the Tokyo Stock Exchange is expensive and inconvenient for Mexican
investors. To make this process easier, a financial institution in Mexico, such
as a bank, can buy Sony’s stock on the Tokyo Stock Exchange and make it
available to Mexican investors. Rather than making the shares directly
available for trading on the Mexican Stock Exchange, the bank holds the shares
in custody and issues GDRs against the shares held. The Sony GDRs issued by the
custodian bank are listed on the Mexican Stock Exchange for trading. In
essence, the Sony GDRs trade like the stock of a domestic company on the
Mexican Stock Exchange in the local currency (Mexican peso).
Depositary receipts, like the shares
they are based on, have no maturity date (i.e., they have an infinite life). Depositary
receipts typically do not offer their owners any voting rights even though they
essentially represent common stock ownership; the custodian financial
institution usually retains the voting rights associated with the stock.
The following example describes the
depositary receipt of Vodafone Group in the United States.
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