Convertible Bonds

Capital Markets

Submitted by:
Sundus Mazher
Momil Fatima
Zainab Sadia
Afshan Sarfaraz
Bilal Wajahat

Submitted
to: Miss
Maha Ijaz

23rd of December, 2016

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Contents
Economic Growth ........................................................................................................................................................... 3
Inflation .......................................................................................................................................................................... 3
USA.............................................................................................................................................................................. 3
Pakistan....................................................................................................................................................................... 4
Commodities: GOLD and OIL ....................................................................................................................................... 4
Monetary Policies ........................................................................................................................................................... 6
Pakistan:...................................................................................................................................................................... 6
USA: ............................................................................................................................................................................ 7
Describe Your Product of Choice: Convertible Bonds ................................................................................................... 8
Historical and Present Dynamics: ................................................................................................................................. 10
Historical: .................................................................................................................................................................. 10
Present: ..................................................................................................................................................................... 12
H: View on Forward Expectations & Recommendations ............................................................................................. 13
References: ................................................................................................................................................................... 15

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Economic Growth
The nominal global GDP of the worlds largest national economy USA is 22%. Current GDP is $18.56
trillion (2016 nominal & PPP), GDP growth is 1.4% (second Q 2016), & GDP per capita is $57,293
(2016 nominal). American economy has shown a faster growth as compared to the past. The average
growth of GDP per year since 1970 is 3.16%. Since the third quarter the average growth has averaged
4.62%. Americas economic growth is due to their smart policies whether reduction in taxes or other
policies related to the growth but now the addition to the policies that Donald trump is suggesting can
bring disastrous change. Investment acts as another factor in the economic development and the boom
in investment of 1990 in which most of the investment was done in plant & equipment for future
growth. These living standards depict the growth. Current problem which is faced by USA is that since
the recession productivity is not stable & it failed to rebound, it is increasing at average rate of 0.5%.

Current GDP of Pakistan is $285 billion & GDP growth is 4.71% & nominal GDP $1550. Pakistans
economy is 25th largest in the world in terms of purchasing power parity. Pakistan is the semi-
industrialized economy. The problem that Pakistan is facing is budget deficit. According to the IMF
chief assessment Pakistan, economic growth will increase because of the foreign investments in
Pakistan (CPEC). According to World Bank, Pakistan poverty decreased form 64.3% in 2002 to 29.5%
in 2014. & budget deficit decrease form 6.4% in 2013 to 3.8% in 2016.

Inflation
Inflation is the rate at which the general level of prices for goods and services is rising and,
consequently, the purchasing power of currency is falling. Central banks attempt to limit inflation, and
avoid deflation, in order to keep the economy running smoothly. In this context the policies play a
strong role.

USA

In December 2011 the inflation in US was recorded as 3.14% and this was the year of hyperinflation.
Onwards from then it has been on constant decrease. High inflation rate of 1.64% was experienced
again in October. The Federal Reserve continuously tried to reconcile government and the people as
government wanted high inflation rates so that they could pay in cheap dollars. The annual inflation
rate since 1913 is 3.22% but the cumulate effects over 20 years is 2275% meaning that a commodity

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costing $100 will now cost $2375. It was observed in 1920 and 1930 that the prices fell actually
because of the great depression. As inflation often has a targeted purpose by the government so the
expected inflation is going to rise up to 2.5% till 2020. People may feel richer but dollars will actually
buy less. According to the consumer price index, a $100 product will cost $102 in 2017.

Pakistan

Core Inflation Rate in Pakistan increased 5.30 percent in November of 2016 over the same month in the
previous year. Core Inflation Rate in Pakistan averaged 7.85 percent from 2010 until 2016, reaching an
all-time high of 11.40 percent in June of 2012 and a record low of 3.40 percent in September of 2015.
The inflation will be 4.5% in 12 months time. The past trends show that inflation has continuously
increased. And by 2020, the inflation rate will be 3.30%. Generally, income groups above Rs35000
were affected the most by 4.3% in October 2016.

Commodities: GOLD and OIL

Commodities exchanges usually trade future contracts on commodities, such as trading contracts to
receive something, say wheat, in a certain month. A farmer raising wheat can sell a future contract on
his wheat, which will not be harvested for several months, and guarantee the price he will be paid when
he delivers; a breakfast cereal producer buys the contract now and guarantees the price will not go up
when it is delivered. This protects the farmer from price drops and the buyer from price rises. These are

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the soft commodities. The hard commodities are gold and oil. In the last week the gold prices in US had
gone down.

Pakistan Mercantile Exchange is the first technology driven, web-based, demutualized commodity
exchange in Pakistan. It is licensed and regulated by the Securities and Exchange Commission of
Pakistan and has a 100 % Institutional shareholding. Gold is also traded over it.

Pakistan Mercantile Exchange Limited started its operations in May 2007 as a fully electronic exchange
with nationwide reach. PMEX provides commodity futures trading platform or market participants to
trade in a wide spectrum of commodity derivatives. The oil prices given by PMEX are as under:

Crude oil is traded both in options and futures in Pakistan. Crude Oil futures are standardized,
exchange-traded contracts in which the contract buyer agrees to take delivery, from the seller, a specific
quantity of crude oil (eg. 1000 barrels) at a predetermined price on a future delivery date.

You can trade Crude Oil futures at New York Mercantile Exchange (NYMEX) and Tokyo Commodity
Exchange (TOCOM).

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Following are the oil and crude prices in Pakistan:

Monetary Policies

Pakistan:

The State Bank of Pakistan (SBP) expects the inflation to increase & the expectation of inflation
dictates what interest rate will be charged.
Due to the likelihood of inflation, the SBP retained the policy rate at 5.75% till the end of the current
quarter & is likely to stand at 5.5% in the next 12 months.
IBA-SBP Consumer Confidence Survey of September 2016 showed the current & expected economic
conditions improving & a major rise in consumer confidence backing up the claim that the domestic
demand is likely to increase.
The economy is expected to expand due to improvement in the industrial activity. The manufacturing
is likely to increase given the prices of inputs will be low along with low interest rates & improved
energy supply. The economic growth is likely to be 4.8% & keeping this in mind the SBP made the
decision for interest rate.
An expected growth in credit rates to about 13%.
Profitability is likely to grow by 27% as interest rates are likely to reverse due to the expected

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 increase in CPI inflation.
The governments policies are focused towards monetary expansion.

USA:
For 2017, the Federal Open market Committee (FOMC) trimmed its interest rate forecast to 1.6%
from 1.9% for March. This implies that it may only raise rates twice next year instead of three times
projected in its previous forecast.
The U.S. Federal Reserve forecasted its interest rates at 0.9%.
The Fed projects, on average, that the federal funds rate will end in 2017 at 1.6% though the analysts
expect that the Fed funds rate will be 1.67%.
US economic growth in 2017 is expected to be 2.3%.
There isnt likely to be significant increase in capital market interest rates.
Trumps fiscal policy may cause the inflation to rise. But the interest rate increase is likely to reduce
due to the global economic environment. A yield level of 2.3% is expected in US in 2017.
The target rate would remain within the current range of between 0.25% & 0.50% due to the slowing
down of the labor market at the point of growth in economic activity.

E: Forward view on Stocks & Bonds

US economy is in recession which has affected the bonds and stocks prices adversely. After the incredible
financial crisis, it is expected that the investors are to wait for longer period in order to have a high return.
Investors want those bonds whose prices dont fall if the inflation rises. The inflation rate has risen through
the year and has been the highest in the last 7 years. This doesnt reflect good prospects for the bonds.
Rising inflation results in low growth prospects. Even in the case of equities, same case applies that the
increasing cost of the businesses will result in less returns and hence low dividends. In USA average
trading of bonds in 2009 was $814.0 Billion and stock market was stock Market was $104.9 Billion.

It is required to hold a bond-fund that has flexibility and one can invest diversely. This not only does reduce
risk but also provide opportunities to invest in shorter maturities because then one has high investing options.
Moreover, if we put light upon the condition of stocks, the returns are going to be lower than the previous
decades. Some say that inflation didnt rise enough so the relative returns are generous and premiums are good
enough. But in March 2016, the inflation rate rose causing major adverse reactions.

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Capital Market: Convertible Bonds

Describe Your Product of Choice: Convertible Bonds

A convertible bond is a corporate bond that can be exchanged by the holder into a
predetermined number of shares of the issuers common stock. Like other bonds,
convertibles pay interest at a fixed coupon rate and can be redeemed at the face (or par value)
of the bond. They also fluctuate in price with changes in interest rates and credit worthiness
of the issuing company, just like other types of corporate bonds. Convertible bonds generally
carry a lower coupon rate than nonconvertible corporate bonds however, the interest rate
usually offers a yield advantage over the common stock dividend rate. When convertible
bonds mature, they can be redeemed at their face value or at the market value of the
underlying common share, whichever is higher. Convertible bonds fits in capital structure as
they are senior to unsecured debt, which is senior to common equity and junior to secured
debt. Convertible bonds captured more upside in bull markets than downside in bear markets.
When the bond is issued the term for the conversion specified at that time.

Conversion Ratio: The conversion ratio is the number of common shares into which a
convertible bond can be converted.

Conversion Price: This the price at which the bonds will converted and trade off. The
conversion price is equal to the face value of the bond divided by the conversion ratio.

Conversion Premium: The conversion premium is the price an investor has to pay above the
conversion value in order to own the convertible security The amount by which the
convertible price exceeds the conversion value is referred to as the conversion premium,
expressed as a percentage. The conversion value, also known as the parity, is equal to the
number of shares represented in the conversion ratio multiplied by the common share price

Forced Conversion: One downside of convertible bonds is that the issuing company has the
right to call the bonds. In other words, the company has the right to forcibly convert
them. Forced conversion usually occurs when the price of the stock is higher than the amount
it would be if the bond were redeemed, or this may occur at the bond's call date. This
attribute caps the capital appreciation potential of a convertible bond.

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Capital Market: Convertible Bonds

Conversion Value: the value of a convertible security if it were to be converted into stock.

Convertible bonds behave in two ways depending upon the situation. At any given point in
time, the trading behavior of a convertible bond can take on either stock or bond
characteristics. Depending upon where the underlying stock is trading in relation to the
bonds conversion price. The security becomes more stock-like as the price of the common
shares rises which means that its participation in the stocks upside potential tends to
increase. As the underlying stock price falls, the convertible becomes more bond like. If the
stock price slips below the conversion price, the convertible trades just like a bond,
effectively putting a price floor under the investment. It is important to note that convertibles
are also subject to the same risk factors as stocks and bonds including market, interest rate
and default risks.

Convertible bonds aim to participate in the upside potential of the equity market while
limiting exposure to downside volatility. Generally, total return convertible bonds have
captured 60-80% of the upside of the underlying equity versus 50% or less of the downside.

Convertible bonds are subject to the risks of both stocks and bonds and are not suitable for all
investors. These bonds can fluctuate in value with the price changes of the companys
underlying stock. If interest rates rise, the value of the corresponding convertible bond will
fall. Many of the companies` that issue convertible bonds are below investment grade, which
means the bonds can be riskier than investment-grade issues. Convertible bonds are often
issued by smaller companies and may be more volatile than securities issued by larger
companies.

Types of Convertible Bonds:

Bond-like: Convertibles in this category are characterized by high yields and high
conversion premiums. Given that the equity option is so far out of the money, the security
behaves almost like a pure debt instrument with little regard given to the option value.

Total Return/Balanced: Convertibles in this category exhibit ideal characteristics of a

convertible investment, characterized by moderate yields/conversion premiums and a good
level of equity sensitivity.

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Capital Market: Convertible Bonds

Equity Sensitive: Convertibles in this category behave very close to a pure equity
investment, characterized by lower yields/conversion premiums and a high degree of equity
sensitivity.

Regional Composition: As of September 2015, the global convertible bond market was
valued at USD 295 billion, of which the United States has the largest share at 63% followed
by European Union at 24%. Meanwhile, Japan and rest of Asia represents the balance at
13%.

Credit rating: Within the US convertible market, about 46% of all outstanding issues are
not-rated (NR) securities and the majority of these NR issues (58%) are large cap companies.
Very often, companies forego obtaining ratings mainly to avoid a lengthy and expensive
rating process.

Default Defaults: In the convertible bond market have been lower than those in the high
yield market. The default rate for convertible bonds within the US has averaged 1.0% versus
3.8% in high-yield over the period 2003 to 2014. Interestingly, not-rated securities had a
lower default rate than investment-grade and high-yield securities.

Historical and Present Dynamics:

Historical:

When did companies first issue convertible bonds?

The first convertibles were issued in the nineteenth century, when the United States was what
we would now classify as an emerging market. Gaining access to capital in a rapidly growing
country often proved challenging. The convertible clause was first added to mortgage bonds
to entice investors to finance the building of railroads. Soon, other companies were also
participating in the asset class, including those involved in steel manufacturing, distilling,
steam pumps, gas pumps, the telephone and the telegraph.

What were some of the key trends in the convertible market in the twentieth century?

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Capital Market: Convertible Bonds

By the 1950s, many growth companies had begun issuing convertibles. Although interest
rates were relatively low in this favorable economic environment, the equity kicker
allowed companies to sell these fixed-income securities with lower yields. In the bull market
of the 1960s, many companies issued convertibles, as mergers-and-acquisitions became the
means to create the mega-conglomerates of the time. Many small- and midsized companies
also issued convertibles as the economy expanded

Recent issuance has been strong against a backdrop of economic growth. Redemptions tend
to be a reflection of issuance trends three to five years earlier. The 1980s saw the United
States in the midst of one of the greatest periods of corporate creation and corporate
restructuring. There were large increases in all types of debt financing, including
convertibles. Household-name growth companies financed much of their dramatic growth by
issuing convertible bonds; for many of these companies, the convertibles were issued at a
time when their ratings were below investment grade. However, in the mid-1980s, large
investment-grade companies also turned to the convertible market. Interest rates were high at
the time, and investors believed that equity prices were undervalued. Since convertible debt
can be issued at rates that are slightly lower than those of regular corporate debt, issuing
convertible securities allowed companies to lower their fixed-income costs. The private
placement market also expanded markedly during the 1980s. Previously, private placement
convertibles had been used extensively in the venture capital market with small issues that
were not very liquid. The introduction of Rule 144a in 1990 created the institutional private
placement market. A private placement can be brought to market quickly without the
voluminous disclosure that a public offering requires. These companies are typically already
well known to the institutional buyers, so underwriting costs can be significantly reduced
through the use of 144a private placements. In the 1990s, Wall Street innovation adapted the
classic convertible bond, producing new types of securities with acronyms such as MIPS,
DECS, ELKS, PERCS, and PRIDES. These securities also expanded the size of the
convertible market, and provided investors with additional opportunities to select more
tailored securities. By the 1990s, the convertible market had become a truly global asset class
(see Figure 6.1). As we discussed in Section 2, convertible issuance is fueled by economic
expansion. During the 1980s and 1990s, one of the most important trends in the global

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Capital Market: Convertible Bonds

convertible market was the growth of the Japanese convertible market. Against a backdrop of
robust economic growth and strong equity market performance, Japan became the largest
issuer of convertibles. A number of European countries also had advanced convertible
markets, including the United Kingdom, France, Australia, Canada, Sweden and Switzerland.
The attributes of each of these markets varied, based on investor and issuer preferences, as
well as regulatory considerations.

Present:

How has the convertible market evolved in the twenty-first century?

The convertible market has continued to evolve in response to a range of factors, including
investor demand, issuer needs, and market influences. More recently, the 2000s saw
contingent convertible bonds rise in popularity. These cocos were convertible into common
stock after the stock price had risen to a level wherein the bond was well into the money,
providing companies with a mechanism to issue convertibles and manage the dilution in
earnings per share. In recent years, we have also seen an increase in contingent convertible
bonds, particularly within the European financial sector. These are also called cocos, but
differ significantly from the cocos of the 2000s. Banks issue cocos to address regulatory
requirements for capital reserves. However, should the issuer come under financial distress,
this newer breed of coco converts into equity or may even be completely wiped out. As a
result, this newer breed of coco lacks the downside protection associated with a traditional
convertible security. Securities with variable conversion ratios represent another innovation
in the convertible market. A corporation will issue a convertible and pair it with additional
warrants with the same strike price as the conversion price. These extra warrants allow the
corporation to issue the bond at a higher premium. From a regional standpoint, todays
convertible market provides investors with a breadth of choices. As shown in Figure 2.2,
issuance has picked up notably in Europe over recent years. We are also encouraged by
trends in emerging markets, particularly emerging Asia and believe emerging markets will
play an increasingly important role in the evolution of the global convertible market.

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Capital Market: Convertible Bonds

H: View on Forward Expectations & Recommendations

While conditions are looking better for stocks, with the Standard & Poors 500 Index ending
the first quarter virtually where it began and high-yield bonds on the rebound, the stability
may not be sustained. Equity strategists forecast more turmoil, while debt strategists at
Morgan Stanley expect the high-yield market to suffer.

The important learning lessons that can be taken from the past 150 years of convertible bonds
to ensure investors are able to fully take advantage of this unique asset class.

Firstly, do detailed credit research. In the years following the Rome, Watertown and
Ogdensburg issuance, hundreds more railroad bonds hit the market. Interestingly, during this
initial convertible bonds market boom, the issuing conditions were all similar, with coupons
hovering around the 7% mark despite the underlying risk of each project varying
substantially. Anyone who invests in convertible bonds must put credit research at the center
of their decision-making process. More detailed analysis from convertible bonds original
investors may have revealed that the Rome, Watertown and Ogdensburg convertible should
have offered a considerably higher coupon and a shorter maturity.

To manage portfolios actively is also crucial. As the convertible bond market grew in
popularity in the early 1900s, the importance of active management became clear. By this
time many household names including General Electric, Westinghouse International Paper
and Western Union had undergone issuances. Then came the stock market crash of 1929 and
as equity markets collapsed only high-quality issuers were able to survive.

These businesses made good on their convertible bond obligations, providing investors with
downside protection. With the convertible bond issued by Richfield Oil Company in 1928, an
investor was able to survive the turbulence in excellent shape. Crucially, at the end of the
downturn, investors were able to take the capital salvaged through the convertible and
reinvest this in equities at a very inexpensive level. This highlights the importance of active
management, particularly in an asset class where the risk-return profile can vary substantially
over time.

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Capital Market: Convertible Bonds

One should also analyze every aspect of the bond. In the period from 1935 to 1970, the
first valuation models were introduced to analyze convertible bonds more precisely (long
before Black & Scholes). This period brought the insight for current investors that a precise
analysis of convertibles is a key to success. This is typically a multi-stage process analyzing
not only the credit risk and optionality in terms or puts or calls, but also the underlying equity
and its exposure to macro-economic or sector trends.

As the market continued to mature, the development of more sophisticated analytical tools
also provided investors with the data and insight to exploit a greater range of opportunities
from price distortions and work out new forms of convertibles such as mandatory convertible
bonds and exchangeable convertible bonds. It also provided investors with a greater sense of
clarity on which innovations were overpriced, allowing for better distinction between
opportunities and non-opportunities.

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Capital Market: Convertible Bonds

References:
http://www.nasdaq.com/markets/crude-oil.aspx

http://www.pmex.com.pk/

http://www.cfapubs.org/doi/pdf/10.2470/rf.v2009.n5.8

http://www.investopedia.com/articles/financial-advisors/070215/pros-cons-convertible-
bonds.asp

http://merage.uci.edu/resources/documents/convertible%20bonds.pdf

http://us.allianzgi.com/MarketingPrograms/External%20Documents/Understanding_Convertible
s_IES_016.pdf

http://www.barclayhedge.com/research/educational-articles/hedge-fund-strategy-
definition/hedge-fund-strategy-convertible-arbitrage.html

https://www.bloomberg.com/news/articles/2016-04-04/convertible-securities-poised-for-
comeback-amid-swinging-markets

http://www.calamos.com/~/media/documents/market-
insights/2015/08/ConvertibleSecurities_18080_0615

pg. 15