Topic 6

Corporate Bond and Convertible Bond

FINA4120– Fixed Income 1

 Till debt us do part
Economist, 3/12/16

• What fixed income instrument pays you 16% per year with only a 2%
default rate?

• Financing divorce lawsuit!

– Novitas Loans, a British firm, is currently lending to 1,500 would-be divorcées
(most are women) or divorcés, at 18% annual interest
– Brendan Lyle of BBL Churchill Group, an American firm with cases in 27 states,
says his role is “part financier and part therapist”

• Biggest risk factor?

– “couple might get back together”

FINA4120– Fixed Income 2

 Outline

• Default Risk
• Rating
– Rating Firms
– Statistical models
– MKV (ideas)*
• Promised Return and Expected Return
• Convertible Bond
– Countrywide case
• CDS *
FINA4120– Fixed Income 3
 Corporate Bonds – Default Risk

• One of the biggest differences between Corporate

Bonds and U.S. Treasury Bonds is the default risk
on corporate bonds

• Corporate bonds are rated on the basis of their

default risk by a few rating companies

FINA4120– Fixed Income 4

 Default
• The precise definition of default is often laid out in the “Events of
Default” section of a credit agreement or bond indenture

• These events include:

– Failure to pay principal or interest on time (payment default)
– False representation (under Reps and Warranties)
– Default on other debt in cap structure (“cross default”)
– Bankruptcy, liquidation, or other insolvency proceeding.

• Technical default occurs when the debtor violates a condition of

a credit agreement can be ground for legal action.
– E.g. Violation of covenant (can be renegotiated and amended for a fee)

FINA4120– Fixed Income 5

 Forum for restructuring?
• Out of court. All negotiations by and among
creditors and the borrower are completed privately.

• In court (Chapter 11 or Chapter 7). All negotiations

occur within a U.S. bankruptcy court presided over
by a judge.

FINA4120– Fixed Income 6

 Chapter 7 – Liquidation

1. Automatic stay freezes all collections against the

firm

2. Trustee is appointed to liquidated the debtor’s assets

3. Liquidation proceeds are distributed according to the

absolute priority rule

4. Firm ceases to exist

FINA4120– Fixed Income
7
 Chapter 11 – Reorganization
1. Pre-petition management stays in control as
“debtor in possession”

2. Debtor is given several “administrative powers” to

assist reorganization

3. Debtor also given exclusivity period for proposing

plan of reorganization

4. The process concludes when a plan of

reorganization is confirmed by the court

FINA4120– Fixed Income

8
 Protection Against Default

• Sinking funds

• Subordination of future debt

• Dividend restrictions

• Collateral

FINA4120– Fixed Income 9

 Default Predictors

• Credit ratings

• Accounting based models (statistical models)

– Credit scoring models
– Traditional ratios analysis (credit analysis)

• Market based models

FINA4120– Fixed Income

10
 Corporate Bonds – Default Ratings

Rating Companies
• Moody’s Investor Service
• Standard & Poor’s
• Fitch
Rating Categories
• Investment grade
– Aaa, Aa, A, Baa by Moody’s ratings
– AAA, AA, A, BBB by S&P ratings
• Speculative grade or “Junk” bonds
– Rated below Baa by Moody’s and BBB by S&P

FINA4120– Fixed Income 11

 Same AAA, different risk
• When it comes to bond ratings, all triple-A grades aren't
created equal.
• When corporations issue debt, the triple-A rating is the
gold standard, awarded to only about a dozen companies.
• But in the trillion-dollar market for mortgage securities,
triple-A ratings were as common as corner coffee shops.
• Triple-A corporate bond ratings depend on the ability of
the firm to make payments while triple-A mortgage bond
ratings depend on what percentage of loans in the pool
backing the bond must default before the triple-A bond
will take a loss.

FINA4120– Fixed Income 12

 Payouts or Debt Rating? WSJ, 02/05/16

“We get value from the AAA credit rating in our business, whether it be access to
financial markets or access to resources,” Jeff Woodbury, an Exxon vice president

Standard & Poor's threatened on Tuesday to strip Exxon of its perfect AAA credit
rating.

FINA4120– Fixed Income 13

 Practice Question

Which bond is considered a “Junk” bond?

a) GE CAPITAL
b) WASHINGTON MUTUAL
c) DELTA AIR LINES
d) SPRINT CAPITAL

FINA4120– Fixed Income 14

 Answer

• C.

FINA4120– Fixed Income 15

 China Bond Market

• Very young market (started around 2006);

• Growing EXTREMELY fast…
• Domestic dominated market
– Major investors are domestic institutions;
– Foreign investors face quotas;
– Since 2017, foreign investors can buy through HK
brokerages.

FINA4120– Fixed Income 16

FINA4120– Fixed Income 17
FINA4120– Fixed Income 18
 Rosy Ratings

• Most corporate bond in earlier stage are State own firms;

• Essentially default-free (before 2014);
– 97 percent of nearly 2,000 non-financial corporate bonds had
ratings of AA or better;
– China Evergrande Group: Offshore bonds are junk, but its onshore
bonds have an AAA
• S&P starts rating business in early 2019
– standards and methodology will be tailored to “fit the local
situation”
– More general rating shopping problem

FINA4120– Fixed Income 19

Default in China Bond Market

FINA4120– Fixed Income 20

 Statistical models

• The general idea is to find factors that enable the lenders to

discriminate between good and bad credit risks.

• Edward Altman has developed a model using financial

statement ratios and multiple discriminant analyses to
predict bankruptcy for publicly traded manufacturing
firms. This model was developed in 1968.

• Other models (Olson Score (1980), etc.)

FINA4120– Fixed Income 21

 The Z-Score Model

• For public companies:

– Z = 1.2X1 + 1.4X2+3.3X3+0.6X4+1.0X5
– X1: (current assets – current liabilities)/total assets
– X2: retained earnings / total assets
– X3: EBIT / total assets
– X4: Market value of equity/Book value of debt
– X5: sales/total assets

where Z is an index of bankruptcy.

• In three tests performed from 1969 and 1999 by Altman and using a
cutoff score of 2.675, the accuracy of the Z-score is around 82-94%.

FINA4120– Fixed Income 22

 The Z-Score Model

• For private companies:

– Z’ = 0.717X1 + 0.847X2+3.017X3+0.420X4+0.998X5
– X1: (current assets – current liabilities)/total assets
– X2: retained earnings / total assets
– X3: EBIT / total assets
– X4: BV of equity / Book value of debt
– X5: sales/total assets

• Z’>2.90: sale zone; 1.23<Z’<2.90: grey zone; Z’<1.23: distress zone.

• A different model for firms in emerging markets (refer to the book by

Altman and Hotchkiss, 2006).

• Zeta model: seven factors (better accuracy than Z-score model)

FINA4120– Fixed Income 23

 Average Z-scores by Ratings

• Based on data from 2000 to 2004

Ratings Average Z-score Std.
AAA 6.2 2.06
AA 4.73 2.36
A 3.74 2.29
BBB 2.81 1.48
BB 2.38 1.85
B 1.8 1.91
CCC 0.33 1.16
D -0.20

FINA4120– Fixed Income

24
Maybe more…

FINA4120– Fixed Income 25

 Market Based Models

• Market implied ratings (Moody’s)

– Translate prices from the CDS, bond and equity
markets into standard Moody’s ratings
– An implied rating is calculated by comparing an entity
or security’s trading price to the trading prices of all
other entities or securities in the same Moody’s rating
category

FINA4120– Fixed Income 26

FINA4120– Fixed Income 27
FINA4120– Fixed Income 28
 Moody’s KMV’s Model
• Equity is a Call Option.
– The underlying asset comprises the assets of the firm.
– The strike price is the principal amount of the debt.

• If at the maturity of their debt, the assets of the firm are greater
in value than the debt, the shareholders have an in-the-money
call, they will pay the bondholders, and “call in” the assets of
the firm.

• If at the maturity of the debt the shareholders have an out-of-

the-money call, they will not pay the bondholders (i.e., the
shareholders will declare bankruptcy), and let the call expire.

FINA4120– Fixed Income 29

• Why does the price of the stock jump?
– “If Valeant doesn’t file its 10-K report by April 29, the company said, its
bank lenders will be able to accelerate payment under Valeant’s credit
agreement—and if it isn’t filed by mid-May, holders of Valeant’s notes could
do the same if at least 25% of the holders of any series of notes demand it.”
– “This isn’t merely a technical matter; failure to file the already delayed results
could set off a chain of events that could leave Valeant in breach of bank-loan
and debt covenants. That in turn could spark a default that could ripple across
the company’s $30.2 billion in long-term liabilities.”

FINA4120– Fixed Income 30

 Trading strategy?

• Back in 2006, bonds of UnitedHealth Group with maturity 2036 were

traded at a large discount to par.

• Noticing that the firm might have to delay their 10k filings, a group of
hedge funds bought the bond and threatened the firm
– “If it doesn't file the paperwork within 60 days, the group says it has the right to
declare the bonds due and payable immediately.”

• More than 25 companies were targeted in 2005-2006. Many had to pay

millions to bondholders to ward off default.

FINA4120– Fixed Income 31

Value of Equity

FINA4120– Fixed Income 32

DD and EDF

FINA4120– Fixed Income 33

Source: Peter Crosbie and Jeff Bohn, 2003, KMV..
KMV Model

FINA4120– Fixed Income 34

KMV (Merton) Model (optional)

FINA4120– Fixed Income 35

KMV (Merton) Model (optional)

FINA4120– Fixed Income 36

Luckin and Car Inc.

FINA4120– Fixed Income 37

FINA4120– Fixed Income 38
History: 2020/03/26

FINA4120– Fixed Income 39

Controlling rates

FINA4120– Fixed Income 40

Potential Risk in US…

FINA4120– Fixed Income 41

 TALF

• Buy not only Treasury bonds…

– Commercial paper
– ABS, MBS…
• Providing liquidity
• Distort risk premium

FINA4120– Fixed Income 42

FINA4120– Fixed Income 43
 Promised Return vs. Expected Return

• Consider a high yield bond

– $100 par, 10% annual coupon, 6m to maturity,
one semi annual coupon left, trades at $90

• What is the promised yield to maturity?

– 6m promised return =
($100 + $5)/$90 = 16.67%

– YTM = 2*16.67% = 33.33%

FINA4120– Fixed Income 44

 Promised Return vs. Expected Return Continued

• Suppose the CAPM holds, markets are efficient

– Bond beta is 0.5
– Market risk premium is 5%
– Risk free rate is 3%

• What is the expected 6m return?

– Expected annual return on the bond =
3% + 0.5*5% = 5.5%
– Expected 6m rate of return on the bond = 2.75%

FINA4120– Fixed Income 45

 Promised Return vs. Expected Return Continued

• Suppose the probability of financial distress is 50% in

6m
• What is the expected recovery rate conditional on
distress?
– Expected 6m return =
0.5*(100 + 5 - 90)/90 + 0.5*(Exp.Recov – 90)/90 = 0.0275 (given)
– 0.5*Exp. Recovery =
0.0275*90 + 45 – 7.5 = 2.475 + 45 – 7.5 = 39.975
– Exp. Recovery = $ 79.95
– Expected loss if there is financial distress is 11.17%
– Check: Expected 6m return =
0.5*16.67% + 0.5*(-11.17%) = 2.75%

FINA4120– Fixed Income 46

 Practice Question

Consider a zero coupon corporate bond, with one year to

maturity, priced at $873 per $1000 face value.
a) What is the Yield to Maturity (BEY) of the bond?
b) Assume an expected return of 12% (Effective Annual Rate)
and a default probability of 6%. What is the implied recovery
rate?
c) Assume an expected return of 6% (Effective Annual Rate) and
a recovery rate of 50%. What is the implied default probability?
d) Moody’s downgraded this bond from a rating of AA to CC.
Do you expect the yield to maturity or the expected return to
change by more? Briefly explain.

FINA4120– Fixed Income 47

 Answer

a. BEY solves 1000/(1+Y/2)^2 = 873 => Y=14.05%.

b. Use the formula ($1000(1-p) + p(recov)$1000)/(1 + E(r ) ).
[.94(1000) + .06(1000)( recov)]/1.12 = 873 => recov = 0.63.
c. [(1-p)(1000) + p(1000)(0.5)]/1.06 = 873 => p = 15%.
d. The YTM should increase by more than the expected
return. This is because the YTM has an additional
component of adjustment that reflects the reduction in
expected cash flows.

FINA4120– Fixed Income 48

Credit Default Swap

FINA4120– Fixed Income 49

 Credit Default Swaps (CDS)

• Insurance against
default
• Fee paid over time
Fee
• This type of contract can Protection Buyer Protection Seller
be written on anything
– e.g., loan, bond, Contingent
sovereign risk, credit payment upon
event of default
exposure on derivative Reference Asset
of reference asset
contract
Protection Buyer

FINA4120– Fixed Income 50

 CDS Structures
• Fixed maturity
• Fee paid until maturity or default
• Various triggering events:
– Bankruptcy
– Credit event upon merger
– Downgrade
– Failure to pay
– Must be verifiable public announcement of the event
• “There’s a bit of a cat-and-mouse game between buyers and
sellers,” said Athanassios Diplas, a former risk management chief
at Deutsche Bank AG who now works as a derivatives consultant.
“No matter how we write the definitions, they’re always going to
try to find a way to go around them. That’s why the definitions
have to be revisited every now and then.”

FINA4120– Fixed Income 51

 CDS Structure

• Various settlement rules:

– Cash settlement = face value – market value at trigger event
• Market value determined by average of dealer quotes
– Physical delivery: deliver defaulted bond for face value
– Digital settlement: fixed payment in event of trigger event
• Contracts usually governed by ISDA rules

FINA4120– Fixed Income 52

 CDS Pricing
• Approach 1: A CDS is like a credit guarantee. The present
value of the insurance can be found using the options pricing
methods.

• Approach 2: Price delivery-settled swap by “no arbitrage” with

reference to underlying securities:
– Risky bond + CDS = Risky free bond
– CDS spread should be equal to credit spread
– Not always

FINA4120– Fixed Income 53

 Assessing Total Credit Risk
• We have abstracted from counterparty risk
• It can be important, especially when it is correlated with the underlying
asset risk, e.g.:

40 bps

U.S. Commercial Korea Exchange

Bank Bank (Baa1
Moody’s)
Contingent
LIBOR + 70 payment upon
bps default of
Hyundai
Hyundai unrated
debt

FINA4120– Fixed Income 54

 Issues

• Benefits
– Hedging
– Risk management without hurting client relation
• Problems
– Empty Creditor / CDS holdup
– Speeding up crisis
– Payoff manipulation

FINA4120– Fixed Income 55

 Empty Creditor Problem
• Imagine the following situation
– You bought $1M bond. To hedge, you bought CDS that will
pay you $600K in the event of bankruptcy
– Now issuer is in deep trouble, bond worth only $250K
– Issuer wants to negotiate with you: “let’s do a debt
restructuring, so you can get 45 cents on a dollar. If not, you
get no more than 20 cents if I file for bankruptcy.”
– The restructuring is good for everyone, but will you support
it?

FINA4120– Fixed Income 56

 June 18, 2009
“Credit-default swaps are pitting firms against their own creditors”

• SIX FLAGS, an American theme-park operator, filed for Chapter 11 bankruptcy protection on
June 13th, bringing its long ride to reduce debt obligations to an abrupt halt. The surprise was
that bondholders, not the tepid credit markets, stymied the restructuring effort

• Pragmatic lenders who hedged their economic exposure through credit-default swaps
(CDSs), a type of insurance against default, can often make higher returns from CDS
payouts than from out-of-court restructuring plans. In the case of Six Flags, fingers are
pointing at a Fidelity mutual fund for turning down an offer that would have granted
unsecured creditors an 85% equity stake. Mike Simonton, an analyst at Fitch, a ratings
agency, calculates that uninsured bondholders will receive less than 10% of the equity now
that Six Flags has filed for protection.

• Some investors take an even more predatory approach. By purchasing a material amount of a
firm's debt in conjunction with a disproportionately large number of CDS contracts, rapacious
lenders (mostly hedge funds) can render bankruptcy more attractive than solvency.

• Some also suspect that CDS contracts played a role in General Motors' filing earlier this
month.
FINA4120– Fixed Income 57
August 5, 2014
“Caesars Said to Consider Debt Plan Offered by Creditors”
Advisers to a group of first-lien creditors that includes Paul Singer’s Elliott
Management Corp. and Bill Gross’ Pacific Investment Management Co. proposed
trimming debt in exchange for a mix of new debt, cash and securities that would gain
value as the company recovers, according to two of the people, who asked not to be
named because talks are private.

The offer begins a process that seeks to restructure about $12.7 billion of bonds at
Caesars Entertainment Operating Co., the most indebted unit, and keep it out of
bankruptcy. Caesars sued more than 30 creditors including Elliott, accusing them today
in a statement of impeding the reorganization process.

December, 4, 2014
“Elliott Said to Buy Caesars Swaps Amid Bankruptcy Talks”
Elliott Management Corp. has been adding to derivatives trades that would pay off if
Caesars Entertainment Corp. defaults as the hedge fund helps orchestrate a bankruptcy
plan for the casino operator’s biggest unit, according to two people with knowledge of
the trading.

FINA4120– Fixed Income 58

Black Stone on Hovnanian CDS

FINA4120– Fixed Income 59

 CDS in the Crisis

• The investigation on housing market

• CDS in “The big short”
• Risks besides counterparty
• Gambling with CDS
• AIG

FINA4120– Fixed Income 60

Collateral Damage --- Behind AIG's Fall

FINA4120– Fixed Income 61

 How did a small brokerage outwits big IBs

• Amherst Holdings (a small brokerage firm) sold CDS on

Mortgage-Backed Securities to JPM, RBS and BoA in Mar
2009
• Price ranges from 80 to 90 cents on a dollar, but default is
almost certain, so IBs expect to get back one dollar in one
month
• $130M bets on around $27M MBS
• IBs were shocked to find that the MBS was paid in full in
Apr (no default) and CDS became worthless
• What happened? Amherst bought MBS and paid it off!

FINA4120– Fixed Income 62

 Convertible Bonds

• Convertible bond allows a holder to convert the

bond into common shares at a fixed ratio
• Convertible bonds could be viewed as corporate
bonds with embedded stock options
• Convertible bonds have characteristics of both
fixed income securities and equity securities

FINA4120– Fixed Income 63

 Convertible Bond Market Continued

• $270bn in 2014, a small corner of the $10 trillion corporate

bond market
• Issuers
– 58% small cap firms (market cap less than $1.25 billion)
– 27% medium cap companies (from $1.25bn to $10.5bn)
– 15% large cap companies (above 10.5 billion)
– Only 17% of the companies have the Standard & Poor’s stock rating of
B+ and above
– Only 21% of the companies have the Standard & Poor’s bond rating of
BBB and above
– A large portion of convertible bonds are issued by smaller firms in
high-growth industries such as computers, electronics, health care,
internet, and semiconductor
*Data from Noddings, T. S., Christoph and J.G., Noddings (2001): “The international handbook of
convertible securities: a global guide to the convertible market,” The Glenlake Publishing Company
FINA4120– Fixed Income 64
Overview of US CB market

JP Morgan research report on CB (2009)

FINA4120– Fixed Income 65

Effective maturity is often shorter than stated maturity, why?

FINA4120– Fixed Income 66

 Convertible Bond Investors
• Money managers
– Purchase the convertible if they are bullish on the underlying equity
– Diversification cross asset classes
– Add alpha to an individual asset class
– Upside participation and downside protection = mkt timing tool
• Arbitrage specialists
– Identify misalignment between the equity market and the convertibles
– Take advantage of the relative mispricing by longing the equity and
shorting the convertible or vice versa
– They hedge their positions continuously and are not about the positive
outlook for the equity

FINA4120– Fixed Income 67

 Convertible Bonds - Example
• LinkedIn issued the following convertible bond on
Nov 2014:
– Size: US$ 1,322.5 million
– Term: 5 years
– Redemption date: 11/01/2019
– Nominal value (par): US$ 1000
– Interest coupon: 0.5%
– Conversion price: US$ 294.5421
– Conversion ratio: 3.3951
– Market price* at issue: 100
– Bloomberg Ticker LNKD 0 ½ 11/01/19
*Market price is always quoted as a percentage of the nominal value.
This means that you have to pay $1000 to buy this bond at issue
FINA4120– Fixed Income 68
 Other features

• Call option:
• With notice period: bondholders can choose to
convert before the call option is exercised.
• Firm may use it as a way to force conversion at
particular time.
• Put option: Standard
• Convert Price: averaged price of a period after the
conversion. Why?

FINA4120– Fixed Income 69

 Convertible Bond Pricing - Intuition
Consider convertible bond by LinkedIn LNKD 0 ½ 11/01/19
• When share price of LinkedIn is very small relative to the conversion price
of $294.54
– The convertible bond is very unlikely to be converted
– The convertible bond is effectively a straight bond and can be evaluated using the
standard bond pricing formula
• When the share price is very high relative to the conversion price
– The convertible bond will certainly be converted to shares
– The convertible bond price will be the conversion value (or parity), which is the
share price times the conversion ratio
• When the share price is close to the conversion price
– There is uncertainty about the conversion
– The convertible bond price would reflect both the straight bond and the embedded
call option on the stock
– The value of the embedded call option increases with the stock volatility

FINA4120– Fixed Income 70

 Convertible Bond Price Diagram
LNKD 0 ½ 11/01/19
180

160

140
Convertible Bond Price (%)

120

100

80

60

40

20

0
100 150 200 250 300 350 400 450
Stock Price

Conversion value Bond value Convertible Bond Price

FINA4120– Fixed Income 71

 Convertible Bond Pricing Approaches
• Breakeven analysis
– Provides a rough estimate of a holding period to compensate
for the convertible bond premium over the underlying equity
• Bond plus equity option approach
– Calculates the price of a convertible bond as a sum of prices
on a straight bond and a call option on a stock
• Multi-factor models
– Advanced models that consider the stochastic nature of
interest rate, credit spread and stock price at the same time

FINA4120– Fixed Income 72

 Breakeven Analysis
• The idea is to match
– Cash premium of buying a convertible bond vs buying an
underlying stock
– The additional income over the breakeven holding period
from a convertible bond’s coupons vs. dividend income from
an underlying stock
• Breakeven period is defined as the holding period to
match the above quantities

• Time value of money and potential changes in dividends

are ignored in this approach

FINA4120– Fixed Income 73

 Breakeven Analysis Example
• Consider the following convertible bond:
– Nominal value (par): US$ 1000
– Interest coupon: 5%
– Conversion price: US$ 25
– Conversion ratio: 40
– Market price at issue: 100
– Share price at issue: $22
– Current dividend yield: 1%
• Breakeven analysis would provide a rough estimate of a
holding period to compensate for the convertible bond
premium over the underlying stock

FINA4120– Fixed Income 74

 Breakeven Analysis Example Solution
• Then the market value of shares in the convertible bond (called
parity or conversion value) is
$22*40 = $880
• Cash premium of owning the convertible bond =
$1000 - $880 = $120
• Annual convertible bond coupon income =
$1000*0.05 = $50
• Annual dividend income on investment in equity =
$880*0.01 = $8.8
• Extra annual income from owning the convertible bond =
$50 - $8.8 = $41.2
• Hence 120
Breakeven period   2.91 years
41.2
FINA4120– Fixed Income 75
 Breakeven Analysis Takeaways

• Breakeven analysis does not provide accurate estimates

for actual convertible bond pricing
• It serves as a reasonable check on convertibles
– Convertible bonds with breakeven period of less than three years are
generally considered acceptable investments
• In choosing investments in convertible bonds make sure
that a convertible bond can not be called within the
breakeven period!!!
– Hard non-call period may be a part of bond’s provisions
– Softcall feature allows to call the bond only if underlying shares’
market price provides at least a specific premium to the conversion
price
FINA4120– Fixed Income 76
Practice question

FINA4120– Fixed Income 77

 Answer

(775-28*20.83)/(52.5-20.83*1.2) = 6.972

FINA4120– Fixed Income 78

 Bond Plus Equity Option Approach

• Price of a convertible bond as a sum of

– Straight bond
– Call option on the underlying stock

• The call option can be valued using the Black-

Scholes formula or binomial trees

FINA4120– Fixed Income 79

Growth of conv arb hedge fund

FINA4120– Fixed Income 80

 Success
• Ken Griffin and Citadel
– Doing conv arb using his own pricing program between
classes from his dorm at Harvard, annual return 70%
– Found citadel in 1990 and its asset under management
grew from $4.5 million in 1990, 12 billions at 2005, 26
billion in 2015

FINA4120– Fixed Income 81

A Case on Possible Convertible Arbitrage
- Countrywide Financial Corp

FINA4120– Fixed Income 82

 Introduction

• When: Friday late afternoon, Oct 22nd, 2004

• Who: Mary Lucas
– Junior trader at First Convergence Inc., a hedge fund
• Where: First Convergence’s trading floor
• What: Mary notices surge in trading on the
convertible bonds of Countrywide Financial Corp
(NYSE: CFC) over the last three days
• The questions is Why?

FINA4120– Fixed Income 83

 Countrywide Financial Corp
• History
– Founded in 1969
– Member of S&P 500
– Provides mortgage banking and other financial services

• Recent performance (as in the case)

– Outperform the S&P 500 index during the last one year
– Rising interest rate hurts its most recent performance
– On Oct 20th, it announced an EPS of $0.94, 7 cents
short of consensus expectation
– Share price plunged by 11% on that day

FINA4120– Fixed Income 84

 Convertible bonds issued by CFC
• The “old” convertible bond
– Convertible into CFC shares

• On Aug 20th, 2004, CFC offers to exchange the “old” bond

to a “new” bond
– The “new” convertible bond is convertible to a mixture of cash and
shares

• 94.7% of the “old” bonds are exchanged to the “new’

bonds

• “New” bonds start trading on Sep 20th, 2004

FINA4120– Fixed Income 85

 What could be the reasons behind the
exchange offer?
• The cash/share settlement allows the company to use a type of
accounting treatment that is less dilutive to its earnings per share.

• Previously, the company had to account for the convertibles as though

they were already converted - a more dilutive earnings per share
calculation - because the convertibles were “in the money”.

• Because Countrywide is settling the par value of these new

convertibles in cash, and any value over that in stock, the dilution is
much less severe.

FINA4120– Fixed Income 86

 The accounting rule
• The computation and presentation of EPS by publicly traded
companies are governed by SFAS 128.

• SFAS 128 requires using the if-converted method for those

participating securities that are convertible into common stock if the
effect is dilutive.”

• The Question is why should market care about how the EPS is
computed?
– The market seems not that smart after all
– In 2007, Amgen Inc changed its accounting method for computing EPS to
account for option expense, the estimated EPS dropped by 4%
– Nothing changed on firm’s fundamentals, but its share price fell 3%

FINA4120– Fixed Income 87

 Stocks and Convertibles

• The “new” bond is deep-in-the-money

– Average price of the CFC stock is $37.
– Mary Lucas noticed that Stock price and bond price
moved closely

• The plunge in stock price and the surge in

convertible trading occurs at the same time

FINA4120– Fixed Income 88

 Exhibit 1 Countrywide Financial Corp --- Daily Stock Price
and Convertible Bond Trading Volume since Sep 20, 2004

45 90000

40 80000

35 70000

30 Q3 earning annouced 60000

on Oct 20, 2004
25 50000

20 40000

15 30000

10 20000

5 10000

0 0
20040927 20040930 20041005 20041008 20041013 20041018 20041021

Stock Price Conv Bond Trading Vol

FINA4120– Fixed Income 89

 Be prepared to discuss these questions:
1. What’s the unusual feature in the New Convertible
Security?
2. Are there trading strategies to take advantage of such
unusual feature?
3. What’s behind the sudden increase in the convertible
bond trading on Oct 20, 2004?
4. What’s the cost to the investors and the company?

FINA4120– Fixed Income 90

 What’s the unusual feature in the New
Convertible Security?
? How are the conversion proceeds determined in the case of the new
convertible security?
? Is this a common practice?
• The new convertible bond can be converted into:
– Cash
– CFC shares

FINA4120– Fixed Income 91

 What’s the unusual feature in the New Convertible
Security?
• The most unusual feature is that the conversion proceeds are
determined by a backward average of closing prices for last 20 trading
days.
– “… multiplied by the average of the closing price of our common stock
… for each day of the 20-day cash settlement averaging period”.

• The more usual settlement method is based on a forward-looking

average of the issuer's stock-price - that is, on an average price based
on a period of time after the conversion is declared.

• Why not just the closing price at conversion?

– Prevent price manipulation

FINA4120– Fixed Income 92

Are there trading strategies to take advantage
of such unusual feature?
• The new convertible bond price and stock price seem to
move closely
– Should it be the case? No
– Stock price moves a lot, the 20-day backward average is not
affected that much, the convertible price should move much less

• The market seems to ignore the “backward averaging”

feature
– Maybe it just didn’t notice this change from the old security to the
new security

FINA4120– Fixed Income 93

Are there trading strategies to take advantage
of such unusual feature?
• If that is the case, you could buy the new convertible bond
following a sharp drop in the stock price and convert it
immediately.

• The bond is lower than the conversion value (since the

conversion value is based on the closing price in the last 20
days).

FINA4120– Fixed Income 94

What’s behind the sudden increase in the convertible
bond trading on Oct 20, 2004?

• On that day, Countrywide's stock dropped 11.6% to $33.17 on the

earnings news, down from $37.50 the prior day.

• The sharp decline in the stock price presents an immediate arbitrage

opportunity. You could buy the convertible bond at $1567.5 and
convert it immediately.

• The backward average of closing stock prices in the last 20 days is

$38.245, which implies a conversion proceeds of $1667.87
(1000+(38.245×46.282-1000)/38.245×33.17), or an immediate profit
of $100.
• Apparently, lots of people were doing it.

FINA4120– Fixed Income 95

 What’s the cost to the investors and the
company?
• Cost to the investor
– It is a zero-sum game
– Investors who bought the bond and converted during
the period from Oct 20th to Oct 22nd made a profit
($100 per bond on Oct 20th). About 150,000 bonds
were traded during this period. Assume all were
converted, the buyers of the bonds made a total profit of
about 150,000×100 = $15M.
– Investors who sold the bond lost the same amount
– If all new securities are converted, profit = $63.7M
FINA4120– Fixed Income 96
 What’s the cost to the investors and the
company?
• Cost to the company
– “the ultimate cost to Countrywide isn't insignificant, …
because it has to settle up with investors at an inflated
stock price, as opposed to the true share value of $31.29
- or the price that the stock is trading Monday” --- Oct
25th, 2004, Dow Jones Capital Markets Report
– Is the analysis right?
• No, Arbitrage opportunity resulted in early exercise of the conversion option
• Investors gave up the “option value”
• Company gained

FINA4120– Fixed Income 97

7 facts and 1 puzzle about default risk

FINA4120– Fixed Income 98

 Facts about default
1. Default rate vary enormously over time
Annual Global Default Counts and Volume Totals
1970-2014
(Source: Moody’s)

FINA4120– Fixed Income 99

 Facts about default
2. Some of the variation can be explained by changes in
the distribution of credit ratings over time

FINA4120– Fixed Income 100

 Facts about default
3. Some of the variation can be explained by variation
in default rates over the business cycle
16.00%

14.00%

12.00%

10.00%

8.00%

6.00%

4.00%

2.00%

0.00%
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
-2.00%

-4.00%

Default rate Real GDP

FINA4120– Fixed Income 101

 Facts about default
4. Investment grade bonds
rarely default while carrying
that rating. However, they do
get downgraded (sometimes
quickly), and some eventually
default

FINA4120– Fixed Income 102

 Facts about default
5. Ratings transition matrices are a useful way of
summarizing the risk of downgrades and default

FINA4120– Fixed Income 103

 Facts about default
6. Average ratings transition matrices fail to capture the
differential risk of upgrades and downgrades over the
business cycle

FIN
FINA4120–
40660 - Debt
Fixed
Instruments
Income 104
 Facts about default
7. Recovery rates vary considerably across securities and
across time

FINA4120– Fixed Income 105

 Correlation between Defaults and Recoveries,
1983-2005

4.00% 70.00%
60.00%
3.00% 50.00% Global Corporate
40.00% Default Rate
2.00%
30.00% Issuer-Weighted
1.00% 20.00% Recovery Rates
10.00%
0.00% 0.00%

9 83 9 85 9 87 9 89 9 91 9 93 9 95 9 97 9 99 0 01 0 03 0 05
1 1 1 1 1 1 1 1 1 2 2 2
year

Both the probability of default and the severity of losses increases in

downturns. Hence credit risk has a positive beta.

FINA4120– Fixed Income 106

 Practice problem

Consider two 7% (annual) coupon corporate bonds, each with

one year to maturity. Both are expected to default with 20%
probability. Investors demand an expected return of 4.5% on
both bonds. The only difference is that in the event of default
the expected recovery rate on the first bond is 75%, and the
expected recovery rate on the second bond is 25%. Use this
information to estimate the difference in the quoted yield to
maturity between the two bonds.

FINA4120– Fixed Income 107

 Answer

Assuming that the recovery rate applies to the promised

cashflow at maturity.

107/(1+y1) = 97.273 => y1 = 10%

107/(1+y2) = 87.033 => y2 = 22.94%

Difference is 12.94%

FINA4120– Fixed Income 108

 Credit Spread Puzzle

• What determines the YTM spread between Treasury’s and

defaultable securities?
• Conceptually the spread can be divided into several components:
– Expected losses
– Premium for market risk ()
– Liquidity premium
– Non credit features include taxes and embedded options

• The “credit spread puzzle” is the observation that expected losses

can explain only a small portion of the historical spread.

FINA4120– Fixed Income 109