3

Convertible Bonds and Mandatory Convertible Bonds

This chapter examines the major characteristics of convertible bonds and mandatory convertible bonds. It covers the terminology, structures and price behavior of these instruments, as well as issuer and investor motivations. Also in this chapter, contingent convertibles – FRESHES, CASHES and ECNs – are covered in detail. Several real case studies are included: a convertible bond issued by the German corporate Infineon, a mandatory convertible bond issued by UBS, a FRESH issued by Fortis Bank, a CASHES issued by Unicredit and an ECN issued by Lloyds.

3.1 INTRODUCTION TO CONVERTIBLE BONDS

3.1.1 What are Convertible Bonds?

Convertible bonds are instruments which give the holder the right to “convert” a bond into a fixed number of the issuer's common stock (i.e., ordinary shares) at a specified price. Convertible bonds have both common stock and straight bond features. Like common stock, convertible bond holders benefit from an appreciation of the issuer common stock. Like straight bonds (i.e., non-convertible bonds), convertible bonds can have cash redemption at maturity and fixed coupon payments. In this way, convertible bonds reflect a combination of the benefits of stocks and those of bonds (see Figure 3.1).

Commonly, convertible bonds tend to pay lower coupons than straight bonds because their holders also participate in the underlying stock appreciation. However, convertible bonds can be tailored to meet an issuer's specific coupon requirements. For example, a convertible bond can be structured to look more like a bond with a high coupon and a high conversion premium, or more like equity, with a low coupon and a low conversion premium. The higher the coupon, the lower the probability of being converted into shares. The lower the conversion price, the higher the probability of being converted into shares. Thus, the higher the probability of conversion, the more equity-like the instrument behaves and the less straight debt-like the instrument behaves (see Figure 3.2).

From an issuer point of view, issuing a convertible has the following advantages relative to issuing common shares:

• If conversion takes place, shares are issued at a premium to the underlying share price on issue date.
• Normally less potential impact on share price.
• Preserves capacity to issue straight equity, as investor base is typically different.
• Generally less sensitivity to “use of proceeds” question.
• Dividend and voting rights are maintained until conversion (in exchangeable bonds).

Similarly, issuing a convertible has the following advantages relative to issuing straight debt:

• Cash coupon payments are lower (for low coupon convertibles).
• Preserves capacity to issue additional debt, as investor base is typically different.
• Usually fewer covenants are required.

3.1.2 Convertible vs. Exchangeable Bonds – Exchange Property

An exchangeable bond is similar to a convertible bond except that exercise by the holder results in conversion into the shares of another company rather than the shares of the issuer itself. Most of the characteristics described in this chapter for convertibles apply also to exchangeable bonds.

Exchange Property

A major difference between convertible and exchangeable bonds lies in the need to own the underlying stock. In a convertible bond and upon conversion, an issuer can issue new shares. Therefore, bond holders of a convertible bond know that the issuer can always meet the conversion requirements if the company has prior approval from shareholders. In an exchangeable bond and upon conversion, bond holders are only certain that their conversion will be met if the issuer owns the underlying stock. That is why in an exchangeable the underlying stock is called the “exchange property”. The terms and conditions of an exchangeable include provisions that secure the use of the exchange property only to meet the exercises under the exchangeable.

3.2 WHO BUYS CONVERTIBLE BONDS?

Convertibles appeal to a broad range of investors with different risk profiles and investment criteria. For example, straight equity fund managers may find convertibles that offer a better risk–reward profile than the underlying shares. The main investors in convertible bonds are dedicated convertible funds and hedge funds.

Dedicated Convertible Funds

Funds fully dedicated to convertibles are one of the two main investors in convertible bonds. These funds buy convertibles primarily attracted by their upside opportunities with limited downside. For these types of fund, the most important factor influencing their decision is the issuer equity story. Other elements that these funds take into account are the pricing, the liquidity and the relative value of the issue. Their investment horizon is medium to long-term.

Hedge Funds

Hedge funds are the other main investors in convertible bonds. Unlike dedicated convertible funds, hedge funds are less focused on the issuer fundamental story. Although hedge fund convertible strategies vary widely, commonly hedge funds are attracted to convertibles because of arbitrage opportunities in these bonds. The term “convertible arbitrage” refers to the trading strategy of identifying convertibles which are not efficiently priced by the market in comparison to prices of other related instruments. Typically, these funds aim to exploit a lower than priced realized volatility. Hedge funds will usually buy an undervalued convertible bond and immunize its sensitivity to variations in the underlying share price at all times. This mitigation strategy is called delta-neutral hedging. The strategy implies selling short a portion of the underlying shares. The portion of the underlying shares to be short takes into account the probability of the convertible being exercised. As a consequence, sufficient borrow of the underlying shares is critical for these types of fund.

Equity Funds

Equity funds have historically used convertibles when they are an attractive alternative to straight equity. For example, in difficult market environments equity funds use convertibles as a defensive strategy to smooth out portfolio volatility. In principle, they invest in convertibles that offer both upside performance similar to the equity and downside protection should the underlying share decline. For these types of fund, the most important factor influencing their decision is the issuer equity story.

Equity Income Funds

These funds are cross-over income-oriented funds that look at convertibles as an alternative to straight equity. Their investment horizon is medium to long-term. For these funds an attractive equity exposure to the underlying stock is crucial and equity research and analysis is important.

High Yield Funds

These funds look at convertibles as an alternative to fixed-income investments. Their investment horizon is medium to long. For high yield funds an attractive coupon is crucial. Credit analysis is an important part of their decision-making process.

3.3 CONVERTIBLE BONDS: THE ISSUER PERSPECTIVE

Many different explanations have been put forward for why entities issue convertibles. My belief is that there is not one all-embracing reason. I identify five main types of motivation for issuing convertibles:

Other advantages for an issuer of a convertible bond are the following:

• If convertibles are converted, the issue of new stock will reinforce the equity base of the issuer.
• Upon conversion, stock is placed at a premium to the stock price prevailing on issue date. Therefore, relative to a common stock issuance, the issuer raises a larger amount of proceeds from the same amount of shares.
• Dividends and voting rights are maintained until conversion, if the issuer holds the underlying shares in an exchangeable bond.
• Limited covenants are included, usually limited to negative pledge and cross default. Commonly, no constraints are included regarding acquisitions or significant changes in the business.
• Documentation is usually very limited.
• Roadshows or other detailed communications are unnecessary.
• Execution is relatively quick. A convertible usually requires a preparation period before launch of two to three weeks only. The placement of the convertible bonds takes a few hours, reducing the exposure to market risk. It also enables the issuer to take quick advantage of favorable market windows, for example convertibles’ high redemption levels, low convertible issuance levels and convertible funds awash with liquidity.
• No effect on basic earnings per share (EPS).

The main disadvantage for an issuer of a convertible bond is the potential dilution for existing shareholders, although less than in the case of a rights issue. Dilution can be avoided if the convertible terms include a “cash option” clause (to be explained later). Another disadvantage for an issuer of a convertible bond is its effect in diluted EPS, as its calculation assumes that the convertible bond will be converted.

3.4 CASE STUDY: INFINEON'S CONVERTIBLE BOND

3.4.1 Main Terms of Infineon's Convertible Bond

In order to become familiar with the terms of a convertible bond, let us describe the main terms of a convertible bond issued in 2009 by the German corporate Infineon Technologies. The terms of the convertible are outlined in the table below:

Infineon's Convertible Bond Terms
Issuer	Infineon Technologies Holding B.V., a wholly owned subsidiary of Infineon Technologies A.G.
Notional amount	EUR 195.6 million
Redemption amount	100% of notional amount
Denomination	EUR 50,000
Issue date	26-May-2009
Maturity	26-May-2014
Underlying stock	Infineon Technologies A.G.'s common stock
Issue price	92.80%
Coupon	7.50%, semiannual Act/Act
Conversion price	EUR 2.61
Underlying number of shares	74.9 million (= 195.6 million/2.61)
Conversion ratio	19,157.088
Conversion premium	25%
Share price at issue	EUR 2.09
Lockout period	From issue date to 24 August 2009
Hard no call	From issue date to 25 November 2011
Soft call	From 26 November 2011. Stock price must equal or exceed 150% of the conversion price (EUR 3.915) for 15 days out of 30 consecutive business days

3.4.2 Conversion Price, Ratio, Premium and Lockout Period

A convertible gives the holder an option to convert the bonds into shares of the issuer at a specified price, the conversion price. The conversion price of Infineon's convertible was set at EUR 2.61. In other words, the conversion price is the price at which shares are effectively “bought” on conversion. At maturity, the bond holder will decide whether to convert the bond based on the following:

• If the share price is greater than the conversion price, the shares to be received are worth more than the redemption amount. As a result, the holder will prefer to convert the bond into shares.
• If the share price is equal to or lower than the conversion price, the shares to be received are worth less than, or equal to, the redemption amount. As a result, the holder will prefer to receive the redemption cash amount.

  Conversion ratio is the number of shares into which each bond denomination is convertible. The conversion ratio remains fixed throughout the life of the convertible bond, although it will usually be adjusted for stock splits, special dividends or other dilutive events, and “reset clauses”. The conversion ratio is equal to the denomination divided by the conversion price. The conversion ratio of Infineon's convertible was 19,157.088 shares (= 50,000/2.61), meaning that an investor holding EUR 50,000 of bonds would convert to 19,157 shares.

  

  Conversion premium is the percentage premium of the conversion price above the share price on issue date. In Infineon's convertible the conversion premium was 25%, meaning that Infineon's share price had to appreciate by at least 25% from its value at the convertible's inception to be worth exercising the conversion right.

  Lockout period is a clause that prevents the holder from exercising the conversion right during this period. In Infineon's convertible, the bond holders could not convert the bond into shares prior to 24 August 2009.

3.4.3 Hard No Call Period, Hard Call and Soft Call Options

Most convertible bonds are issued with a call right, that gives the issuer the right, but not the obligation, to force the bond holders to redeem the bond before its maturity date. Usually the call can be exercised by providing a notice period. An issuer can call a convertible bond to take advantage of refinancing the bond at cheaper levels (which can reduce financing expense) or to force bond holders to convert debt into equity (which can reduce debt levels). Upon the bond being called, the holder has the right to choose between (i) redemption at the call price (par or at accreted value) in cash and (ii) conversion into shares. As the call right may cap the equity upside by reducing the time value of the conversion right, the inclusion of a call right will tend to diminish the value of a convertible bond. Thus, a call right constitutes a disadvantage for the holder and a plus for the issuer. Callable convertible bonds usually include hard no call and soft call protections.

Figure 3.3 shows a simulated path of Infineon's share price. Five periods have been chosen to explain the mechanics of the convertible's soft call clause:

• In period 1, Infineon could not exercise its call right. Although the soft call trigger was surpassed during a substantial number of days, the bond could not be called as it was in its hard no call period.
• In period 2, Infineon could not exercise its call right. Although the hard no call period had elapsed, the number of days that Infineon's share price was trading above the trigger was zero (i.e., less than 15 days) during the previous 30 consecutive business days.
• In period 3, Infineon could not exercise its call right. Although the soft call trigger was surpassed and the bond was in its soft call period, the bond could not be called as the number of days that Infineon's share price was trading above the trigger was less than 15 days during the previous 30 consecutive business days.
• In period 4, Infineon could not exercise its call right for the same reasons mentioned for period 3.
• In period 5, Infineon could exercise its call right. The soft call trigger was surpassed, the bond was in its soft call period and the number of days that Infineon's share price was trading above the trigger was more than 15 days during the previous 30 consecutive business days.

3.4.4 Put Rights

A put right is a feature giving the holder the right, but not the obligation, to sell back the bond to the issuer. It helps the holder to get rid of the bond under adverse market conditions such as flat stock prices, rising issuer credit spreads and rising interest rates. Thus, a put right constitutes a disadvantage for the issuer and a plus for the holder. Most puttable convertibles can be put back to the issuer at par for cash.

The inclusion of puts can substantially reduce the cost of financing. The issuer can pay a lower coupon and/or obtain a higher conversion price than in non-puttable convertibles. Commonly, put rights can only be exercised at specific dates. For example, a seven-year convertible bond may have a put right exercisable on the third and fifth anniversary of the bond life. If the exercise of the put option is likely, the issuer will face a potential refinancing risk at the put date.

In assessing whether or not to ask for redemption on a put date, bond holders will compare the fair value of the convertible with the redemption price on this date:

• If the fair value of the convertible is greater than the redemption price (100%), bond holders will not ask for redemption. This situation may occur when the stock price trades above the conversion price or close to the conversion price. The exercise of the put right is not optimal because, by exercising the put, the bond holder would give up the time value of the conversion option.
• If the fair value of the convertible is lower than the redemption price (100%), bond holders will ask for redemption. This situation may occur when the stock price trades well below the conversion price, and/or when the credit spread of the issuer has widened notably since the bond was issued.
• If the fair value of the convertible is equal to the redemption price (100%), bond holders are theoretically indifferent between exercising the put option and keeping the convertible.

In order to highlight how the put right exercise works in practice, let us assume that the terms of a convertible bond include a put right that allows the bond holder to redeem the bond early on 15 June 20X1 (the “put settlement date”). The terms of the put right (see Figure 3.4) state that the put right can be exercised by the bond holder providing there is a “put option notice” during the “put notice period”. The put option notice period starts on the day that is 61 calendar days prior to the put settlement date (i.e., on 15 April 20X1) and ends on the day that is 31 calendar days prior to the put settlement date (i.e., on 15 May 20X1).

A bond holder seeking to exercise his/her put right must complete a “put option notice” and deliver it to the bond agent during the put notice period. Once the bond holder has tendered the notice, it can only be withdrawn with the consent of the issuer. On 15 June 20X1, the put settlement date, the exercised bonds become immediately due and payable.

3.4.5 Additional Clauses: Cash Option, Cash Top-up, Lock-up Period, Tax Call

A cash option is a feature enabling the issuer, at its sole discretion, to deliver to the bond holders that have chosen to convert the bond a cash amount reflecting the then prevailing value of the underlying stock, instead of delivering the underlying stock. The cash equivalent value is determined on the basis of the average closing stock price during a number of days (e.g., five) following the issuer decision to elect the cash option. This clause allows the issuer to avoid dilution upon conversion.

A cash top-up is a feature enabling the issuer to deliver shares at maturity whatever the stock price performance, even if the stock trades below the conversion price. Usually if the conversion price is not reached, additional cash compensation is added to the share delivery. The cash top-up feature provides the issuer with certainty regarding the underlying shares disposal.

A lock-up period is the period during which no entities of the issuer's group can sell shares and/or enter into equity-linked instruments based on the underlying stock.

A tax call is a feature enabling the issuer to early redeem the bond. The issuer is usually incorporated under the laws of tax favorable jurisdiction. As a result, all payments in respect of a convertible bond by the issuer are usually made free and clear of, and without withholding or deduction for, any taxes, duties, assessments or governmental charges of whatever nature imposed, levied, collected, withheld or assessed by the issuer jurisdiction authorities. In the event the issuer has to pay additional amounts, so its payments compensate for such withholding or deductions, the issuer can request early redemption of the convertible bonds. However, bond holders typically have the option to elect their bond to not be redeemed, but no such additional amounts will be paid.

3.4.6 Value of a Convertible Bond at Maturity

At maturity and in absence of the issuer being bankrupt, a convertible bond is worth the larger of (i) its cash redemption amount and (ii) the market value of the shares into which it is convertible, as shown in Figure 3.5 for Infineon's convertible.

3.4.7 Value of a Convertible Bond during its Life

A convertible bond can be split into two components (see Figure 3.6): a bond part and an option part. The bond part represents the coupon payments and the potential redemption in cash at par. The option part represents the right to exchange the bond for a fixed number of shares. The total value of the convertible is the sum of the value of these two components.

• The bond value is the present value of the coupons and principal due on the debt component. It represents the value floor of the convertible bond, assuming that the option component is worthless. The main factors influencing the value of the bond component are the bond coupon, the market level of the credit spread of the issuer, the bond maturity and the market level of interest rates.
• The option value is the value of the bond holder's call right embedded in the convertible bond. The strike price of the option is the conversion price. The main factors influencing the option value are the conversion price, the underlying stock market price, the implied volatility of the underlying stock, the expected dividends, the repo rate, the bond maturity and the market level of interest rates.

During its life, the value of a convertible bond has the profile depicted in Figure 3.7. The graph shows the value of a convertible bond as a function of the underlying share price. We can split the graph into four different areas:

• A distressed area. In this area the stock price is very low. The issuer is in distress and the market is discounting with a significant probability that the issuer will be unable to repay the notional amount at maturity. The value of the convertible is below the bond floor.
• An out-of-the-money area. In this area the stock price is notably lower than the conversion price and as a result the probability of the convertible being exercised is quite low. The convertible behaves like a straight bond. Its price becomes more dependent on interest rates and the creditworthiness of the issuer and less on stock price. Thus, the bond trades close to its bond floor price.
• An at-the-money area. In this area the stock price is close to the conversion price. The convertible behaves like a mix of a straight bond and a stock.
• An in-the-money area. In this area the stock price is well above the conversion price. The convertible behaves like a stock. Its value becomes more dependent on the stock price and less on interest rates and the creditworthiness of the issuer. The convertible price is quite close to the stock price.

The following table summarizes the impact on the total value of a convertible, and the value of its bond and option parts, of an increase in the specified variable, assuming everything else is equal:

There are other factors with a qualitative nature that may also affect the value of a convertible bond, for example:

• The underlying equity story.
• The convertible market overall strength.
• The issuer sector performance.

3.5 DELTA SHARE REPURCHASE STRATEGY

Hedge funds take a long position on a convertible and take a short position in the underlying common stock. Hedge funds will not short 100% of the underlying shares, but rather the percentage of the total amount that immunizes their position to movements of the underlying stock price. This percentage is referred to as the “delta” (in Chapter 1 the reader can find a detailed explanation of the delta concept). As a result of the stock sale, at issuance the underlying common stock price may experience a downward pressure.

In order to offset this downward pressure, an issuer can use part of the proceeds of a new convertible bond issue to repurchase the “delta” shares (i.e., the investors’ short positions), as shown in Figure 3.8. Delta shares bought back at issue are taken out of the outstanding share count, resulting in an immediate and permanent accretive effect. For example, let us assume that the initial delta of Infineon's convertible was 28% and that 50% of the bond holders were going to short the underlying stock at issuance. Infineon would have acquired 14% of the underlying stock, or 10.49 million shares (= 14% × 74.91 million). Because the stock was trading at EUR 2.09 on issue date, Infineon would have spent EUR 21.92 million (= 10.49 million × 2.09). Infineon would then need to decide what to do with the treasury shares acquired, whether to sell them gradually onto the market or to keep them until a potential conversion of the bond.

3.6 MANDATORY CONVERTIBLE BONDS

A mandatory convertible is an equity-linked instrument that performs mostly like common shares but has a higher income stream. These issues are mandatorily convertible (hence the name), at maturity or upon redemption, into common shares, irrespective of the price at which the shares are trading. The coupon at issue is usually higher than the current dividend yield of the underlying common stock.

3.7 RATIONALE FOR ISSUING MANDATORY CONVERTIBLES

Many different arguments have been put forward for why entities issue mandatory convertibles. My belief is that there is not one all-embracing reason. I identify six main types of motivation for issuing mandatory convertibles:

The main drawback for mandatory convertible issuers is paying a higher coupon than on straight non-convertible debt.

3.8 RATIONALE FOR INVESTING IN MANDATORY CONVERTIBLES

An investment in a mandatory convertible is a yield-enhanced investment in the underlying shares. As such, a mandatory offers no downside protection to an investor apart from the higher yield. A mandatory convertible presents the following advantages compared with an investment in the underlying shares:

• The investor receives a coupon that exceeds the dividend payments distributed to the underlying securities. However, the higher yield comes at a price: the investor is obliged to exchange the convertible for shares at a premium to the share price at issuance.
• The investor may be more protected in case the issuer files a bankruptcy petition before the final conversion date. The level of subordination of the convertible holders relative to the other claimants, whether the underlying note was senior or subordinated, prior to conversion date depends on the legal terms of the convertible. Commonly, if an issuer becomes insolvent prior to the convertible bond maturity, the contract terminates and the investors have no obligation to settle on the equity purchase. The notes, however, remain outstanding and participate as debt of the bankrupt debtor for recovery along with other senior subordinated or junior subordinated notes of the issuer, depending on the specific terms of the note.

The following is a disadvantage compared with an investment in the underlying shares:

• The investor may receive shares upon conversion at a premium relative to the share price at issuance. This is the case for most fixed parity mandatory convertibles.

3.9 FIXED PARITY MANDATORY CONVERTIBLES

A fixed parity mandatory convertible is a bond mandatorily convertible at maturity into stock at a fixed conversion ratio. Thus, investors receive a fixed number of shares at maturity. The conversion ratio is fixed through the life of the bond. The bonds are issued at a premium to the initial value of the underlying shares (typically 10–20%), compensated for by a coupon providing investors with a yield pick-up. From an investor's perspective, a fixed parity mandatory convertible functions like a high-yielding investment in the underlying equity.

3.9.1 Case Study: Banco Santander's Fixed Parity Mandatory Convertible

This case walks through the mechanics of fixed parity mandatory convertibles, using a real-life example: a fixed parity mandatory convertible issued by Banco Santander in 2007. The mandatory had the following terms:

Banco Santander's Mandatory Convertible Bond Terms
Issue date	4-October-2007
Issuer	Santander Emisora 150, S.A.U. (100% owned and guaranteed by Banco Santander S.A.)
Issue proceeds	EUR 7 billion
Notional	EUR 7 billion
Maturity date	4-October-2012 (5 years)
Coupon	7.30% until 4-October-2008, and Euribor plus 2.75% thereafter until the maturity date
Conversion price	EUR 16.04 per share (a 20% premium relative to the EUR 13.37 stock price on issue date)
Number of shares upon conversion	436,408,978 shares
Conversion by holder	Holders can convert early on 4-October-2009, 2010 and 2011, and must mandatorily convert on 4-October-2012

In a very general sense, the structure can be looked at as a yield-enhanced investment in common shares from which the investor trades away part of the underlying shares’ upside in return for a higher coupon.

Figure 3.9 shows the number of shares to be received upon conversion by the investors in Banco Santander's mandatory convertible bond. This number is fixed to 436,408,978 shares, independently of Banco Santander's stock price at conversion.

From an issuer point of view, a fixed parity convertible bond has the following advantages:

• The stock is issued at a premium upon conversion.
• The instrument is considered as equity by the rating agencies.
• The instrument is accounted for as equity, except the coupons.
• The coupons are commonly tax deductible.

From an issuer point of view, a fixed parity convertible bond has the following drawbacks:

• Coupons are higher than the coupons of comparable straight debt.
• On issue date, the stock price of the underlying may experience a sharp fall as a result of investors selling the underlying to initially delta-hedge their positions. The delta of the instrument is 100%. As a result, investors immunizing their investment to changes in the underlying stock price need to sell all their underlying shares in the stock market.

3.10 VARIABLE PARITY MANDATORY CONVERTIBLES

Variable parity mandatory convertibles are securities which are mandatorily convertible into common stock at maturity and have no fixed conversion price. The number of shares received upon conversion will depend on the common stock price at maturity. The most common variable parity mandatory structure is called DECS. This type of mandatory structure is described in the following section.

3.11 DIVIDEND ENHANCED CONVERTIBLE SECURITIES

DECS stands for “Dividend Enhanced Convertible Securities” or “Dividend Enhanced Convertible Stock” or “Debt Exchangeable for Common Stock”. It is the most common mandatory convertible structure. Although used to denote the same type of mandatory convertibles, there has been a hodgepodge of names. The names that fall under this category include PIES, DECS SAILS, ACES, PRIDES, TAPS, PEPS, EPICS, TIMES, MARCS, MEDS and some of the STRYPES. The instrument has full downside similar to holding common shares, a dead zone between the lower and the upper conversion price, and partial upside above the upper conversion price.

3.11.1 Conversion Mechanics of a DECS

In a very general sense, the structure can be looked at purely as a yield-enhanced investment in common shares from which the investor trades away part of the underlying shares’ upside in return for a higher coupon. In other words, the security is like an investment in the underlying shares plus a sale of a call spread on the shares. From the issuer point of view, it is like a forward sale of the shares plus the purchase of a call spread.

In order to describe the conversion mechanism of a DECS, let us assume that a company called ABC Corp. issues the following DECS:

ABC DECS Terms
Instrument type	DECS
Issuer	ABC Corp.
Notional	EUR 1 billion
Underlying shares	ABC Corp. common shares
Maturity date	3 years
Coupon	8%, paid annually
Share price on issue date	EUR 100
Lower conversion price	EUR 100 (100% of the share price on issue date)
Upper conversion price	EUR 120 (120% of the share price on issue date)

At maturity, the DECS mandatorily converts into a number of shares that is a function of ABC's stock price at maturity. The conversion premium has a different meaning for a DECS than for a fixed parity mandatory convertible. The conversion price of a DECS varies according to the level of the underlying stock price at the date of conversion, being limited by the lower and upper conversion prices. The lower conversion price is usually the stock price prevailing at issuance. The upper conversion price is set at a premium to the stock price at issue, 20% in our example. Therefore, the number of shares received by the bond holder upon conversion depends on the price of the underlying stock upon conversion. Figure 3.10 shows the payoff structure in terms of common shares received by the DECS investors. If ABC's stock price has declined below the EUR 100 lower conversion price, typically the issue price, investors receive the maximum number of shares.

If ABC's stock price at maturity is between the lower conversion price and the upper conversion price, then investors receive shares worth the DECS notional:

If ABC's stock price at maturity is above the upper conversion price (i.e., the upper strike price), investors receive the minimum number of shares:

3.11.2 Anatomy of a DECS

Let us analyze the DECS from an investor point of view using our previous example. Let us assume that the whole issue was acquired by one investor and that he/she holds the DECS until maturity. The investor would be investing EUR 1 billion in the DECS on issue date, receiving the 8% coupon during the life of the bond, getting the underlying shares upon conversion and selling the shares immediately after conversion. The value of the investment at maturity has the profile depicted in Figure 3.11. The graph shows the value of the investment at maturity as a function of the underlying share price at maturity, ignoring the DECS coupon. The graph also shows a EUR 1 billion investment in the underlying stock (i.e., an investment in 10 million shares), ignoring dividends. We can split the graph into three different areas:

• An equal performance area, in which the investment in the DECS resembles an investment in the underlying shares. In this area the share price at maturity is below the lower conversion price (or the share price at issuance). Upon the DECS conversion, the investor would be receiving 10 million shares. These shares will then be sold in the market, generating a loss. Ignoring the coupon, the investment would be equivalent to having invested in 10 million shares from the beginning. However, the investor received an 8% coupon, probably a much higher yield than the underlying shares dividend. Therefore all things taken into account, the investor was better off investing in the DECS rather than buying the underlying shares.
• A flat area, in which the investment in the DECS resembles no investment at all (or to be precise, an investment in a non-convertible bond). In this area, the share price at maturity is between the lower and upper conversion prices. Let us assume that the shares are trading at EUR 110 at maturity. Upon conversion, the investor receives 9,090,909 shares (= EUR 1 billion/110). The investor would then sell the shares in the market, receiving EUR 1 billion (= 9,090,909 shares × 110). Therefore, the investor receives an amount equal to his original investment, so it is like the investor had not invested in the DECS. However, during the life of the DECS the investor received the 8% coupon. Thus, all things being taken into account, it is like an investment in a straight bond that pays an 8% coupon. Ignoring coupons and dividends, the investor would have been better off investing in the underlying shares rather than investing in the DECS.
• An underperformance area, in which the investment in the DECS resembles an investment in the shares acquired at the upper conversion price. In this area, the share price at maturity is above the upper conversion price. Let us assume that the shares are trading at EUR 150 at maturity. Upon conversion, the investor receives 8,333,333 shares (= EUR 1 billion/120). The investor would then sell the shares in the market, receiving approximately EUR 1.25 billion (= 8,333,333 shares × 150), realizing a EUR 250 million [= 8,333,333 shares × (150 – 120)] profit. Therefore, the investment in the DECS is like an investment in 8,333,333 shares acquired at EUR 120. The investor would have been better off investing directly in the underlying shares: the investor would have invested in 10 million shares at EUR 100, realizing a EUR 500 million [= 10 million shares × (150 – 100)] profit. However, we also need to take into consideration the DECS's 8% coupon relative to the stock dividends, which would have diminished the underperformance.

3.11.3 Embedded Derivatives in a DECS

From an issuer's point of view, the DECS mandatory can be viewed as a forward sale of the maximum number of shares plus the purchase of a call spread (see Figure 3.12), plus a string of coupon payments. The option premium from the purchase of the call spread is then paid to the investor in the form of higher coupon payments. Therefore, the present value of the yield pick-up (the amount by which the DECS yield exceeds the yield of a same maturity non-convertible debt from the same issuer) equals the premium of the call spread.

The call spread can be split into a purchased call with a lower strike and a sold call with a higher strike and lower number of options. DECS typically set the lower conversion price at the level of the common shares price at the time of issuance, which is the price at which the purchased call in the call spread is struck (i.e., the lower strike). At issuance, the mandatory is priced with a so-called conversion premium, which refers to the strike price of the sold call option (the upper strike). In our example, the lower strike price was set at EUR 100 and the upper strike price was set at 120. Therefore, ABC Corp. was long (i.e., purchased) a call with strike EUR 100 on 10 million shares and was short (i.e., sold) a call with strike EUR 120 on 8.33 million shares, as shown in Figure 3.13.

From an investor point of view, the DECS mandatory can be viewed as containing one forward purchase of the maximum number of shares and the sale of a call spread that partially limits equity upside. In exchange for the loss of a portion of the shares’ upside, the investor receives a high periodic coupon.

3.11.4 Pricing a DECS

Previously, we saw that a DECS mandatory can be viewed as a forward sale of the maximum number of shares plus the purchase of a call spread plus a string of coupon payments. The sum of the present value of each component has to equal zero. Therefore:

3.12 CASE STUDY: UBS's DECS

This case walks through the mechanics of variable parity mandatory convertibles, using a real-life example of a DECS.

On 9 December 2007, UBS entered into a binding agreement with the Government of Singapore Investment Corporation Pte Ltd and an investor from the Middle East to issue mandatory convertible notes (MCN) with a face value of CHF 13 billion, subject to the approval of a capital increase by an EGM of UBS shareholders. At the EGM held on 27 February 2008, UBS's shareholders approved a conditional capital increase to issue up to 277,750,000 new shares to satisfy the conversion into UBS shares of the MCN.

On 5 March 2008, the Swiss bank UBS issued the MCN with a face value of CHF 13 billion. The terms of the MCN are outlined in the following table:

UBS's Mandatory Convertible Bond Terms
Issuer	UBS Convertible Securities (Jersey) Ltd
Notional	CHF 13 billion
Issue date	5-March-2008
Maturity date	5-March-2010 (i.e., 2 years from issue date) Potential early termination possible under certain circumstances)
Coupon	9% of notional, payable annually each 5th March
Reference price	CHF 51.48 The reference price was set as the average of (i) and (ii) but not more than 10% higher or lower than (i): (i) closing price on 7-December-2007: CHF 57.2 (ii) volume-weighted average price over three days before the EGM
Final price	Share price at maturity
Minimum conversion price	CHF 51.48 (100% of the reference price)
Maximum conversion price	CHF 60.23 (117% of the reference price)
Conversion at maturity	The mandatory convertible notes will be redeemed via conversion into a number of UBS shares, according to the following schedule: If final price is at or below the minimum conversion price:
	Notional/Minimum conversion price If final price is above the minimum conversion price and below the maximum conversion price: Notional/Final price If final price is at or above the maximum conversion price: Notional/Maximum conversion price
Voluntary early conversion by the holder	The holder can convert the MCN early, starting six months following the payment date and ending on 20th trading day prior to the maturity date
Anti-dilution provisions	If UBS A.G. issues new capital and the issue price of the new shares is below 95% of the market price, the conversion price would have to be adjusted for the value of the subscription rights. As a result, both the minimum and the maximum conversion price would be adjusted downwards If UBS A.G. issues new capital in excess of CHF 5 billion at a share price below the minimum conversion price, a reduction of the maximum conversion price would be triggered. If the new shares are issued at an offering price below CHF 44, the conversion price would be fixed at the level of the minimum conversion price and the maximum conversion price would fall away

If the MCN was converted at maturity, it would be converted for UBS shares at a price, called the “conversion price”, linked to the prevailing market price of UBS shares on conversion date. The total amount of shares that the MCN holders would receive would then be calculated by dividing CHF 13 billion by the conversion price. The conversion price was set within a range of CHF 51.48 (the minimum conversion price) and CHF 60.23 (the maximum conversion price). There are basically three different scenarios for conversion at maturity (see Figure 3.14):

• If the prevailing share price was at or above the maximum conversion price – CHF 60.23 – the conversion price would be CHF 60.23. In this case the MCN holders would receive 215,839,283 shares (= 13 billion/60.23), the minimum number of shares.
• If the prevailing share price was below CHF 60.23 and above the minimum conversion price – CHF 51.48 – the conversion price would be the prevailing share price. In this case the MCN holders would receive a number of shares calculated as 13 billion/share price.
• If the prevailing share price was at or below CHF 51.48, the conversion price would be CHF 51.48. In this case the MCN holders would receive 252,525,253 shares (= 13 billion/51.48), the maximum number of shares.

Through the lifetime of the MCN, the holders would receive an annual coupon of 9% of the nominal.

3.13 SPECIAL CLAUSES IN CONVERTIBLES

3.13.1 Dividend Protection Clauses

Each time a dividend is distributed to the underlying stock of a convertible/exchangeable bond, its bond holders are penalized for any excess of this actual dividend relative to the dividend assumed when the convertible was priced. As a result, convertible/exchangeable bonds commonly include dividend protection clauses. Compensations to the bond holders due to dividend protection mechanisms can be made in the form of cash, which will prevent any further dilution, or via an adjustment of the conversion ratio/price, which may be more appealing to the rating agencies. A dividend protection clause can take several forms:

• A dividend pass-through mechanism, in which all ordinary and extraordinary dividends, in cash or in kind, distributed to the underlying are being passed directly to the bond holders proportionately to their bond holding. The inclusion of a dividend pass-through mechanism results in a lower fixed coupon because during the life of the investment the bond holders are expected to receive the dividends in addition to the coupons. The compensation to the bond holders can be executed either through a payment in cash – via an additional coupon – or through an adjustment to the conversion ratio.
• A dividend threshold mechanism, in which any excess ordinary and extraordinary dividends distributed to the underlying relative to an assumed string of dividends are passed to the bond holders. At inception, a discrete chain of dividends is assumed and used to price the convertible. Any distributions to the underlying shares in excess of this pre-defined dividend chain threshold are passed to the bond holders either in cash or through an adjustment of the conversion ratio.
• A combination of dividend pass-through and dividend threshold mechanisms.

Dividend pass-through mechanisms are uncommon in convertible or mandatory convertible bonds. Even if the issuer of these bonds holds all the underlying shares in its balance sheet, it is not going to receive dividends on these shares because issuers do not distribute dividends to its treasury shares. As a result, any compensation paid to the bond holders through a dividend pass-through mechanism would require the issuer to pay it out of its own cash resources, penalizing the issuer.

Dividend threshold mechanisms are commonly included. At issuance, the chain of discrete dividends assumed is usually based on analysts’ consensus estimates for the underlying stock. The assumed chain of discrete dividends is disclosed in the terms and conditions of the convertible/exchangeable.

Under both dividend pass-through mechanisms and dividend threshold mechanisms in convertible bonds, it is unlikely that the dividend compensation is implemented through a cash payment to the bond holders because it would require the computation of the delta of the conversion right, a parameter not directly observable in the market. Therefore, most dividend compensations in convertible bonds take place as an adjustment to the conversion ratio, and hence to the conversion price. This is not the case in mandatory convertible bonds, especially in fixed parity mandatory convertibles, that have a delta of 100% (or close to 100%). Thus, in mandatory convertible bonds, a transparent dividend compensation in cash may be implemented.

Sometimes, the dividend compensation passed to the bond holders contains a discount relative to the theoretical dividend compensation. This is often the case in dividend pass-through mechanisms. For example, an issuer of an exchangeable bond may suffer a withholding tax when receiving dividends on the underlying shares. In order to avoid being exposed to a dividend risk, the issuer may include a discount to the theoretical compensation. This discount takes into account the taxes levied on the actual dividends.

3.13.2 Coupon Deferral Clauses

One of the motivations for issuers of convertible or mandatory convertible bonds is to increase the equity credit from rating agencies. In order to increase equity recognition, convertibles sometimes include coupon deferral clauses. These clauses allow an issuer to defer its convertible coupon payments. A deferral is not elected at complete discretion of the issuer, but subject to a set of restrictions, for example:

• The issuer not having announced dividends to its common stock.
• The issuer not receiving bank/insurance regulator approval (for banks and insurance companies).
• The issuer not having bought back or redeemed any of its own stock.
• The issuer not having paid back or paid interest on any convertible securities ranking pari passu to the convertible bond.

Coupon deferral clauses can be structured in the following ways:

• Accumulation of deferred coupons, payable at the earlier of issuer call, takeover event and maturity.
• Acceleration of conversion into the maximum number of shares in the event of default on a coupon payment.
• Payment of the coupon in shares.

3.13.3 Call Option Make-whole Clauses

Sometimes mandatory convertibles include a make-whole clause that protects the bond holders in the event of early exercise of the issuer call option. Most make-whole clauses are defined as one of the following two definitions:

• The investor receives a given number of unpaid coupons in one lump sum. This is the most common way to define a make-whole clause. Remember that a mandatory convertible pays a coupon higher than a coupon of comparable straight debt. An early termination of the mandatory convertible implies that the bond holders will not receive the remaining high coupons. A make-whole amount corresponds to the prepayment of the remaining coupons, which the issuer is obliged to pay in case of an early termination of the instrument as a result of the issuer's own actions. In such an event, the issuer is required to make an additional payment that is derived from a formula based either on the present value or the sum of the remaining coupon payments, including any deferred payments.
• The investor gets back the time value that the conversion option had at issuance. For example, if a bond holder paid par for a convertible bond, the time value of the conversion represented 15% of the bond total value at issuance, the bond is called and the bond holder decides to convert, the bond holder would receive the underlying stock plus an extra 15% of the bond issue price.

3.13.4 Change-of-control Make-whole Clauses

Sometimes non-mandatory convertibles include a clause that protects the bond holders in the event of a takeover. If the stock holders of a convertible's underlying stock receive a cash offer for their shares, the stock price suddenly rises to the level of the offer and thereafter the stock price remains stable unless another offer is received. As a result, convertible bond holders can suffer substantial losses because the time value of the conversion option suddenly and completely disappears.

In June 2004 Mandalay Resort stock holders received a cash offer from MGM. Mandalay Resort's convertible did not include a cash takeover protection and their bond holders logged staggering losses. Hedge funds took a long position in the convertible and shorted the common stock. These hedge funds lost money on the short position and did not recover that on the long position because the convertible price did not increase in lock step with the common stock.

A takeover make-whole provision, also called cash change-of-control make-whole clause, is meant to compensate convertible bond holders for the sudden negation of the remaining option value. A takeover make-whole provision is usually triggered in the event the issuer is acquired in a transaction that includes more than a specific percentage, for example 10%, in cash. In such an event, the issuer is required to make an additional payment to the bond holders. Therefore, the cost is absorbed by the acquirer.

3.13.5 Clean-up Call Clauses

Often the terms of a convertible bond include a clause, a clean-up call clause, that allows an issuer to redeem the remaining bonds at any time. This right can only be exercised if a percentage of the bonds have already been redeemed, converted/exchanged into stock or repurchased. This percentage is usually set at a high level such as 85–90%. This right can only be exercised for all, but not some only, of the bonds outstanding. The issuer has to provide a minimum number of days’ notice, 45 days for example.

3.13.6 Net Share Settlement Clauses

In order to reduce the dilutive effect upon conversion of the bond, a “net share settlement” clause may be included in the terms and conditions of a convertible bond. This clause allows a gradual dilution when the stock price exceeds the conversion price. A net share settlement clause lets an issuer of a convertible bond settle up to the convertible's principal amount in cash and pay the conversion option's in-the-money amount in shares. Since the principal amount is redeemed for cash, an issuer will have to refinance the debt upon a call.

The number of shares to be delivered upon conversion is a function of the stock price upon conversion, as follows:

In the case of Infineon's convertible:

The underlying stock will have to appreciate considerably before the actual shares issued begin to approach the nominal shares underlying the convertible issue. Figure 3.15 shows, for Infineon's convertible, the number of shares to be delivered by Infineon were the net-share settlement clause included in the terms of the bond. For example, with Infineon shares trading at EUR 4.50 upon conversion, 172% of the conversion price, Infineon would need to deliver 31.5 million shares. This number is notably lower than the 74.9 million shares to be delivered were the net-share clause not included in the terms of the bond.

3.14 CONTINGENT CONVERTIBLES: FRESHES, CASHES AND ECNS

The inclusion of structured conversion clauses permits a wide range of structural possibilities to meet issuer needs or investor demand. Contingent convertible bonds, also called “CoCos”, are bonds that are mandatorily convertible into common stock in a certain prescribed circumstance, called the triggering event. CoCos begin their life as straight bonds, and absent their triggering event, will behave as such until maturity. CoCos were very popular in the United States because unlike regular convertible bonds their potential dilution was not included in the computation of the diluted number of shares (i.e., CoCos were not included in the diluted earnings per share computation), until conversion. A change in the US accounting standards eliminated the favorable treatment of CoCos relative to regular convertible bonds and, as a consequence, their issuance dried up.

Following the credit crisis of 2007–2008, CoCos became an interesting instrument to enhance bank regulatory capital. Several issues took place in Europe under different names, like FRESH, CASHES and ECN bonds. This section examines three contingent convertible instruments – FRESH, CASHES and ECN. A different type of contingent instrument, the SCN, is described briefly at the end of the section.

FRESH and CASHES are undated highly subordinated mandatory convertible bonds that convert into common stock only after the stock price rises sharply. These instruments do not include a possibility of redemption in cash. Thus, FRESH and CASHES have characteristics of both perpetual bonds and mandatory convertibles, being treated as debt by the tax authorities and as equity by the banking regulators. The bond holders only have a pledge on the underlying shares and can opt to convert their bonds for a fixed number of shares.

ECNs are dated or undated bonds that convert into common stock if the issuer bank regulatory capital falls below a predefined threshold.

3.14.1 Case Study: Fortis's FRESH Instrument

On 7 May 2002, the Belgian/Dutch bank Fortis issued a FRESH (Floating Rate Equity-linked Subordinated Hybrid) instrument through its Luxembourg-domiciled subsidiary Fortfinlux S.A. Fortis used this subsidiary because at that time under Belgian law options with an expiry date of more than 10 years were not permissible. FRESH, a name given by JP Morgan, is essentially a floating rate perpetual bond that mandatorily converts into shares under certain conditions. The instrument represented a combination of four characteristics, including an undated maturity, no redemption in cash, a floating rate coupon and an automatic, as well as optional, exchange into Fortis shares. The issue was intended to strengthen Fortis's solvency, as for regulatory purposes the FRESH was treated as part of Tier 1 capital. The following table summarizes the FRESH bond terms:

Fortis's FRESH Bond Terms
Issuer	Fortfinlux S.A.
Co-obligors	The parent companies of Fortfinlux S.A.: Fortis S.A./N.V. and Fortis N.V., jointly and severally
Instrument	Floating rate equity-linked subordinated hybrid (FRESH) bond
ISIN code	XS0147484074
Rank	Below all debt and preference shares, but senior to ordinary shares
Issue date	7-May-2002
Notional amount	EUR 1.25 billion
Underlying shares	39.7 million Fortis S.A./N.V. shares
Maturity	Perpetual, subject to acceleration call and exchange right
Coupon	Euribor 3M + 1.35%, paid quarterly each 7th February, May, August and November
Coupon payment	Coupon normally paid in cash, but can be paid in shares to a value of 103% of the cash coupon if (1) no common stock dividend is paid; (2) the common dividend for a fiscal year represents a yield of less than 0.5%; or (3) there is a default on senior-ranking debt
Exchange price	EUR 31.50
Conversion premium	30% premium over the price of Fortis shares on issue date (EUR 24.23)
Issuer call	None
Acceleration call	The bond will automatically be converted if, at any time after the seventh anniversary of the issue date, Fortis stock for 20 consecutive trading days is equal to or greater than 150% of the conversion price (i.e., EUR 47.25)
Issuer put	None
Exercise right by bond holders	At any time from 40 days after the date of issuance, investors have the option to exchange the instruments for Fortis shares at the conversion price
Stock settlement coupon	To be covered later

The FRESH bond was undated and carried a cash coupon of 3-month Euribor plus 1.35% payable quarterly in arrears. The exchange price, EUR 31.50, was set at a 30% premium above the price of Fortis stock on issue date. The FRESH bond was guaranteed by Fortis S.A./N.V. and Fortis N.V., jointly and severally. At any time starting 40 days after the issue, holders of the FRESH bond had the right to exchange the FRESH for Fortis common stock at the exchange price. Furthermore, all the outstanding FRESH bond would be automatically exchanged into Fortis shares if, at any time after the seventh anniversary of the issue date, Fortis stock price traded at or above EUR 47.125, which was equal to 150% of the exchange price, for 20 consecutive trading days. Coupons relating to the FRESH bond ranked junior to any indebtedness or obligation, including preference shares, of the co-obligors, and senior to any common stock of the co-obligors, including the Fortis common stock. The sole recourse of the FRESH bond holders against any of the co-obligors was the underlying shares on which a right of pledge was granted for the benefit of the bond holders.

Concurrently with the issuance of FRESH bonds, Fortis issued 39.68 million new shares for market value (EUR 962 million) to JP Morgan. The shares were subsequently purchased by the issuer – Fortfinlux – and pledged to the collateral agent – JP Morgan – for the benefit of the bond holders.

Simultaneously, Fortis entered into a total return swap with the issuer, giving Fortis the right to the value of the underlying Fortis shares upon conversion, as well as to all future dividends paid on those Fortis shares.

The issue of the bond was intended to be classified as Tier 1 capital by the Belgian banking regulator and to maximize the equity treatment by the rating agencies. That is why the bond included features such as:

• Undated maturity.
• Mandatorily convertible into common stock.
• Subordinated ranking.
• Stock settlement coupon clause.
• No step-up call and put features.

The first main characteristic of the instrument was that it had no maturity date (i.e., was perpetual) and would remain outstanding until conversion.

The second main characteristic of the instrument was that its principal amount would not be paid in cash. The FRESH could be exchanged for Fortis shares at a price of EUR 31.50 per share at the discretion of the bond holder, at any time from the day that was 40 days after the issue date. From 7 May 2009, the bond would be automatically exchanged for Fortis shares at a price of EUR 31.50 per share if the price of the Fortis share was equal to or higher than EUR 47.25 on 20 consecutive trading days.

The third main characteristic of the bond was its subordinated ranking. The FRESH bond constituted direct and subordinated obligations of each Fortfinlux S.A., Fortis S.A./N.V. and Fortis N.V. as co-obligors, jointly and severally. The FRESH was subordinated to all other loans, subordinated loans and preference shares, but ranked senior to ordinary shares.

The sole recourse of the bond holders against any of the co-obligors was the 39.7 million underlying shares that were pledged by the issuer in favor of the bond holders. In other words, in the event of bankruptcy proceedings applicable to all of the co-obligors, the bond holders’ sole right with respect to the principal amount of the FRESH bonds was the right to exchange their FRESH bonds for the underlying shares. Notwithstanding the foregoing, in the event of bankruptcy proceedings applicable to all of the co-obligors, the bond holders would continue to have claims for any past due coupons.

The fourth main characteristic of the bond was its stock settlement coupon feature. The bond paid a quarterly cash coupon of Euribor 3-month + 1.35% on the outstanding notional amount. All coupons which were payable during one year after the first announcement by Fortis stating an intention to propose that no dividend on the Fortis shares be declared – or that a dividend be declared that represented a dividend yield in any fiscal year lower than 0.5% – until the day first occurring after the first public announcement by Fortis that a dividend on the Fortis shares that equalled or exceeded in aggregate a 0.5% dividend yield, would be paid in stock (so-called “alternative coupon”). Note that on an annual basis and before Fortis's board of directors decided what dividend it would distribute, Fortis needed authorization from the Belgian bank regulator to distribute such dividend. Therefore, were Fortis solvency to be weak, the FRESH bond holders would be receiving shares rather than cash. The amount of shares would be such that their value represented 103% of the coupon. This obligation was, however, subject to the availability of sufficient authorized capital at the level of both co-obligors. Nonetheless, the co-obligors were contractually obliged to use all reasonable efforts to ensure that there was available at all times authorized capital equal to one year of “alternative coupons”.

Any shortfall in the payment of an “alternative coupon” under the FRESH bond in the event of insufficient authorized capital was deferred (so-called “postponement event”) until Fortis shareholders approved resolutions for a new authorized capital, at which time the shares would be issued at the then prevailing market price. On the expiry date of the “postponement event”, Fortis would be obliged to utilize the remaining authorized capital to pay the “alternative coupon”, and hence issue new shares, at the then current market price.

The final main characteristic of the bond was that it had no call and put rights. Neither Fortis nor the FRESH bond holders could redeem the bond early. However, bond holders could convert the bonds into shares. Therefore, the bond would remain outstanding until conversion.

Before this deal, the only proven way to achieve core Tier 1 capital was to issue shares or, in certain jurisdictions and under certain conditions, mandatory convertible bonds. The problem with such instruments was that dividends and, in most jurisdictions, interest coupons on mandatory convertible bonds were not tax-deductible. FRESH bonds solved this problem by combining the mandatory conversion feature, thus complying with banking regulatory capital guidelines and rating agencies’ requirements, with no fixed maturity, thereby satisfying the tax authorities. The latter attached importance to the fact that the bonds may never be converted, and thus treated them as debt for tax purposes. As a result, Fortis was allowed to fully deduct the coupon payments.

A legal issue surrounded financial assistance and other capital protection laws in Belgium and Holland. The laws prevented a company from financially assisting the acquisition of its own shares by a third party. Thus, Fortis had to avoid binding itself or providing a guarantee on the bonds, because this could be seen as financially assisting the acquisition of its own shares.

3.14.2 Case Study: Unicredit's CASHES Instrument

By a resolution passed on 5 October 2008, Unicredit's board of directors approved a plan of measures aimed at strengthening Unicredit's capital in a total amount of EUR 3 billion through the issuance of 972 million new shares in a rights issue, and resolved to propose the capital increase to an EGM. Unicredit was Italy's largest bank in terms of assets. The resolution was approved by Unicredit's EGM on 14 November 2008 setting the rights issue offer price at EUR 3.083, equal to the price of the common stock of Unicredit at close of trading on 3 October 2008, which was the last trading day before the meeting of the bank's board of directors on 5 October 2008. The rights issue subscription period started on 5 January 2009 and ended on 23 January 2009. Due to the highly volatile stock market environment, Unicredit's stock price during the rights offering, around EUR 1.30, was notably below the offer price. As a result, most investors balked at buying shares in the rights offer. Only 4.6 million shares were subscribed under the rights issue (0.5% of the total). The unexercised options were later offered by Unicredit on the stock exchange during the period from 9 to 13 February 2009, but none of them were purchased.

The rights issue was fully underwritten by Mediobanca. In performance of the underwriting agreement and in order to ensure a good outcome for the capital increase, Mediobanca had the obligation to underwrite the number of newly issued shares corresponding to any rights remaining unexercised even after the offering of unexercised rights on the stock exchange. On 23 February 2009 Mediobanca subscribed for 967.6 million shares, for a countervalue of EUR 2.983 billion, corresponding to the rights that remained unsubscribed following the rights issue. On the basis of the underwriting agreement a CASHES (Convertible and Subordinated Hybrid Equity-linked Securities) instrument was issued, served by any shares not subscribed under the rights issue. The 967.6 million shares subscribed by Mediobanca were then used as underlying for the issuance of a CASHES bond. On 23 February 2009 Unicredit, through the transaction's fiduciary bank – Bank of New York Luxembourg -- issued the CASHES instrument whose terms are summarized in the following table:

Unicredit's CASHES Bond Terms
Issuer	Bank of New York Luxembourg
Obligor	Unicredit S.p.A.
Instrument	Convertible and subordinated hybrid equity-linked securities (CASHES) bond
ISIN code	XS0413650218
Rank	Below all debt and preference shares, but senior to ordinary shares
Issue date	23-February-2009
Notional amount	EUR 2.983 billion
Underlying shares	967.6 million Unicredit shares
Maturity	15-December-2050, subject to acceleration call and exchange right
Coupon	Euribor 3-month plus 4.5%, paid quarterly
Coupon payment	Coupon paid in cash. The coupon will be paid if cash dividends are distributed in relation to Unicredit shares and if profits are shown in the consolidated financial statements for the preceding financial year. Any amount due on any coupon that is not paid, either in full or in part, for any given period is no longer due in any subsequent period
Conversion price	EUR 3.083
Conversion premium	237% (using a EUR 1.30 Unicredit's stock price on issue date)
Acceleration call	The bond will automatically be converted if, at any time after the seventh anniversary of the issue date, Unicredit's stock price for 40 consecutive days is equal to or greater than 150% of the conversion price (i.e., EUR 4.6245)
Exercise right by bond holders	At any time from 40 days after the date of issuance, investors have the option to exchange the instruments for Unicredit shares at the conversion price
Dividend protection	Bond holders would receive pro-rata any amount exceeding a dividend yield of Unicredit of 8%, to be calculated on the basis of the price of the shares recorded during the 30 business days preceding approval of the financial statements

The bond had a notional amount of EUR 3 billion and paid a quarterly coupon, paid in arrears, at a variable rate of Euribor 3-month plus 450 basis points. The coupon was paid if cash dividends were distributed in relation to Unicredit shares and if profits were shown in the consolidated financial statements for the preceding financial year. The coupon was not cumulative. Therefore, any amount due on any coupon that was not paid, either in full or in part, for any given period was no longer due in any subsequent period. Additionally, the CASHES bond holders would receive pro-rata any amount exceeding a dividend yield of Unicredit of 8%, to be calculated on the basis of the price of the shares recorded during the 30 business days preceding approval of the financial statements.

The CASHES had a 15 December 2050 maturity date and did not include the possibility of redemption in cash. However, it could be converted into Unicredit stock. The CASHES had a conversion price fixed at EUR 3.083. Conversion was possible, at the request of the bond holders, at any time starting at least 40 days from the issue date. Conversion would be automatic upon the occurrence of certain events, including the following:

• Following the seventh year after issue, the market price of Unicredit's common stock exceeded 150% of the conversion price (i.e., EUR 4.625, subject to any adjustments), for at least 20 days during any given period of 30 consecutive days.
• Unicredit's aggregate, consolidated or stand-alone capital requirement fell below 5% (or any other threshold set out in the applicable supervisory legislation for the purpose of absorbing losses in innovative capital instruments).
• Unicredit breached any of its payment obligations undertaken pursuant to the usufruct contract.
• Unicredit was/had been declared insolvent or was/had been in liquidation.
• The depositary bank was/had been declared insolvent or was/had been in liquidation.
• The maturity date had been reached.

The CASHES were mostly placed by Mediobanca among the main shareholders of Unicredit (Fondazione Cassa di Risparmio di Verona, Vicenza, Belluno e Ancona; Fondazione Cassa di Risparmio di Torino; Carimonte Holding S.p.A.; the Allianz Group and the Central Bank of Lybia). For them, the main attractiveness of the CASHES bond was its high coupon. The sole recourse of the CASHES bond holders against the obligor with respect to the notional amount was equal to the 967.6 million Unicredit shares that the depositary bank had pledged in favor of such holders.

For bank regulatory purposes, the CASHES bond was treated as part of Tier 1 capital. The CASHES constituted direct and senior obligation of Unicredit.

Building Blocks of the Transaction

The transaction had the following building blocks (see Figure 3.16):

It would have been easier if BoNY also acted as depositary bank. The depositary bank would own shares representing 7% of Unicredit's share capital. Two elements prevented BoNY from becoming the depositary bank: (i) such an ownership of Unicredit would require the Bank of Italy's approval and (ii) the entity was not legally entitled to enter into the usufruct and swaps agreements required.

Flows During the Life of the CASHES

During the life of the transaction, the following flows would take place (see Figure 3.17):

Cash Flows upon Conversion of the CASHES

Each time a conversion took place, the following flows occurred (see Figure 3.18):

Overall Position of the Depositary Bank

It can be seen from the flows analyzed earlier that the depositary bank was not exposed to any risks. The agreements it entered into with the different parties perfectly passed through any flows it received.

• No credit risk to Unicredit because any default by Unicredit would trigger the automatic conversion of the CASHES.
• No credit risk to BoNY as the shares pledged to BoNY by the depositary bank were fully collateralized.
• No market risk to Unicredit shares because they would be delivered to the CASHES bond holders upon conversion.
• No funded position because the acquisition of the shares at inception was financed by the cash collateral received from BoNY under the pledge agreement.
• No impact on its regulatory capital, due to all the previous reasons.

3.14.3 Case Study: Lloyds ECN

In December 2009, Lloyds Banking Group plc (“Lloyds”) carried out a capital-raising program to avoid participating in a British government asset protection scheme. The program had an initial target size of GBP 21 billion to be raised through a GBP 13.5 billion rights issue and a GBP 7.5 billion offer to exchange subordinated bonds for ECNs (Enhanced Capital Notes). The ECNs were subordinated debt with maturities ranging from ten years to perpetual maturities. The unique feature of the ECNs was that their contingent conversion condition was not linked to Lloyds’ common stock price reaching a certain level nor could they be converted at the discretion of the bond holders. The ECNs automatically converted into Lloyds’ common stock if the Group's published consolidated core Tier 1 capital ratio fell to less than 5%. In contrast with FRESH and CASHES, investors would receive common stock at a time when both the capital ratios of the issuer and its stock price were diminished. The ECNs’ conversion could add additional selling pressure caused by the former bond holders selling down their newly received stock holdings, accelerating the stock price decline. Another difference from FRESH and CASHES is that ECNs were not convertible into common stock at the option of the bond holder.

The following table shows the main terms of one of the ECNs issued by Lloyds:

Lloyds’ ECN Bond Terms
Issuer	LBG Capital No 1 plc
Guarantor	Lloyds Banking Group plc
Instrument	Enhanced capital notes (ECN) bond
ISIN code	XS0471767276
Rank	Subordinated
Issue date	15-December-2009
Notional amount	USD 1.26 billion
Maturity	Perpetual, subject to call right, redemption due to taxation and redemption for regulatory purposes
Coupon	8% to 15 June 2020; then USD Libor 3-month plus 6.405%, paid quarterly
Conversion price	GBP 0.592093
	The conversion price was calculated as the greater of (i) the VWAP of the stock for the five-day period ending on 17 November 2009 and (ii) 90% of the closing price on 17 November 2009
Call right	Callable at par by issuer on each coupon payment date, commencing on 15 June 2020, redemption due to taxation and redemption for regulatory purposes
Redemption due to taxation	On occurrence of a tax event
Redemption for regulatory purposes	On occurrence of a capital disqualification event
Mandatory conversion	Bond automatically converts into common stock at the conversion price if the Group's published consolidated core Tier 1 capital ratio falls below 5%
Exercise right by bond holders	None

ECNs’ Redemption Rights

Lloyds could only redeem the perpetual ECNs early in the following two circumstances:

• A tax event had occurred and was continuing. A tax event was deemed to have occurred if (i) Lloyds was obliged to pay additional tax as a result of a change in UK tax law which could not be avoided by taking reasonable measures, or (ii) as a result of such change in tax law Lloyds would be entitled to (a) a tax deduction in respect of its financing expenses in relation to the ECNs or (b) have any loss resulting from such deduction taken into account when computing the group's tax liabilities, and in each case Lloyds could not avoid the event by taking reasonable measures.
• A capital disqualification event had taken place and was continuing. A capital disqualification event was deemed to have occurred if (i) at any time the ECNs no longer qualified for inclusion in the lower Tier 2 capital of Lloyds, or (ii) at any time the ECNs had ceased to be taken into account for purposes of any “stress test” applied by the British banking regulator in respect of the consolidated core Tier 1 ratio.

Attractiveness of the ECNs to Lloyds

The advantages of the ECNs issue were the following:

Attractiveness of the ECNs to Bond Holders

The attractiveness to the bond holders was the ECNs’ high coupon. The coupons were set a large premium above the USD Libor interest rates or Lloyds’ dividend yield. Our ECN paid a quarterly coupon of 8% to 15 June 2020 and thereafter USD Libor 3-month plus 6.405%.

Another interesting feature to the bond holders was that the ECNs’ coupons contained non-discretionary payment provisions. Coupons on contingent convertible instruments are frequently deferrable and non-cumulative, or can be satisfied in common stock. Therefore, Lloyds’ ECNs reduced the uncertainty regarding the coupon payments as Lloyds could not waive them. If Lloyds failed to make payment of an ECN coupon, the bond holders could institute legal proceedings against Lloyds to enforce such payment.

3.14.4 Case Study: Rabobank's SCN

This case highlights a version of contingent capital bonds issued by banks to increase their capacity to absorb losses in times of stress. In contrast with contingent convertible bonds, the SCNs are written down rather than being converted into common stock. In this case, the value of the SCN would be written down by 75% and the remaining 25% returned to investors if the issuer's core Tier 1 ratio breached 7%. This instrument is an interesting alternative for unlisted banks.

On 12 March 2010 Rabobank, an unlisted triple-A rated Dutch cooperative bank, issued a EUR 1.25 billion 10-year fixed rate Senior Contingent Note (SCN) issue, priced at an annual coupon of 6.875%. Since Rabobank was unlisted, it was not able to issue instruments that converted into common stock. Instead it issued an instrument that included a “write down” feature to be triggered if a trigger event occurred.

A trigger event occurred if, on any date (called an “initial trigger date”) during the period from the issue date to a few days prior to the maturity date, the “equity capital ratio” of Rabobank was less than 7% (as certified by two members of Rabobank's executive board, on behalf of the executive board). Such trigger event had to continue on the date (called the “subsequent trigger test date”) falling 20 business days after the initial trigger date to trigger the write-down feature, to allow Rabobank to take measures to restore the ratio.

If a trigger event occurred and was continuing on the relevant “subsequent trigger test date”, then (i) the principal amount of the SCN automatically and permanently would be reduced to 25% of their original principal amount, and (ii) Rabobank immediately would redeem the SCN at 25% of the original principal amount together with any outstanding payments.

“Equity capital ratio” was defined as the ratio of the “equity capital” to the “risk-weighted assets”, at such time calculated by the issuer on a consolidated basis. On issue date, the equity capital ratio of the Rabobank Group was 12.5%. Rabobank undertook to publish the equity capital ratio at least semiannually.

“Equity capital” was defined as the aggregate EUR amount of all instruments representing capital paid up or contributed to the Rabobank Group by its cooperative members and retained earnings of the Rabobank Group, at such time calculated by the issuer on a consolidated basis in accordance with the accounting standards applicable to the Rabobank Group at such time.

“Risk-weighted assets” were defined as the aggregate EUR amount of all risk-weighted assets of the Rabobank Group, calculated by the issuer on a consolidated basis in accordance with the rules and regulations of the Dutch Central Bank.

The offering was designed to ensure that Rabobank's core capital was strengthened in the very unlikely event that the bank's equity ratio was to fall below 7%. If the SCN principal amount was permanently reduced to 25% of its original principal amount, it would allow the bank to book a gain, enhancing its core Tier 1 capital.

The requirement that, following the trigger of the write-down feature, Rabobank had to redeem the SCN in cash could subject it to liquidity pressure. Rabobank would need to pay EUR 313 million (= 25% × 1.25 billion). Rabobank might need to either borrow or sell some of its assets. Due to the large fall in its core Tier 1 ratio, other banks could be unwilling to lend and any assets to be sold could be subject to liquidity difficulties.

From an investor point of view, the market value of the SCN could show substantial gaps. Because investors in the SCN would suffer a loss of a substantial proportion when the trigger event occurred, any indication that the equity capital ratio was trending toward the trigger event could have a large adverse effect on the market price of the SCN. More precisely, the SCN bond holders were exposed to the fluctuation in the equity capital ratio. As a result, the SCN bond holders were exposed to the variations in Rabobank's equity capital and risk-weighted assets. Because of the nature of the trigger event, it was very difficult to predict with any certainty when or if a write-down would occur, although Rabobank undertook to publish the equity capital ratio at least semiannually. For example, the basis of calculation of the risk-weighted assets could vary due to changes in the relevant rules and regulations of the Dutch Central Bank. Accordingly, trading behavior in respect of the SCN was very different from trading behavior associated with other types of hybrid bond.

However, Rabobank had a triple-A rating as it had always been amongst the most conservative banks in the world. By investing in the SCN bond holders expected Rabobank's unwavering commitment to prudence to continue for the following ten years.