Bonds With Warrants and Embedded Options

Bonds With Warrants and Embedded Options

Prepared By:Mr. Japan Shah

B.Com, LL.B, MBA, CS Inter

Bonds/ Mr. Japan Shah 2

• 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

Bonds…


• 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.

Who can invest…


• 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

Terminology in 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

Types of 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

Returns From Bonds


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


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


Value of a Warrant

• The market price of the warrants fluctuates between the minimum and the maximum limit

• The minimum Value = (Ps-Pe)* NWhere 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


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


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


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


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


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


Types of Warrants

• Detachable Warrants• Puttable Warrants• Wedding Warrants• Naked Warrants


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…


• Downside Risk of Investment in Convertible Bonds

• Characteristics of Investing in Convertible Bonds

• Value of Conversion Benefits--- PREMIUM


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


• Conversion Parity Price= Bond Price ---------------- No. of Shares on Conversion per Warrant• Break Even Point= Conversion Premium ------------------------------ Interest Income- Dividends


Callable Bonds- Components

• Two transactions take place in these kind of bonds..

A. Purchase of Non-Callable BondB. Sale of Call option

• Price of Callable Bond= Price of Non-Called Bond – Price of Call option


Puttable Bonds- Components

A. Purchase of Non-Puttable BondsB. Purchase of Put option on the Bond• Price of Puttable Bond= Price of Non-Puttable

Bond + Price of Put Option


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


Features of FRNs

Reference Index

Quoted Margin to reference Rate

Reset Frequency

Observation Date

Maturity Date


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


Other Features of FRNs

Call Feature

Put Feature

Cap Feature

Floor Feature

Collar Feature


Risks in FRNs

Interest Rate

RiskDefault Risk


Valuation of FRNs

• Current Interest• Annuity Stream• Par Bond


Modern Forms of Bonds

Dual Currency Bonds

Equity Index Linked Notes

Commodity –Linked Bull and Bear Bonds

Swap –Linked Bonds

Thank You…

Bonds With Warrants and Embedded Options

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