Submitted by: Submitted by ajaa1982
Views: 744
Words: 1264
Pages: 6
Category: Business and Industry
Date Submitted: 04/12/2011 03:21 PM
Executive Summary
Late in 2003, Wells Fargo, one of the nation’s top financial firms was considering their first issuance of convertible bonds. Even when this was not their usual way of financing and experts agreed that a top company like this one should not finance via convertible bonds, there could be a market opportunity. This case will explain the characteristics of convertible bonds and the strategies implied in them. We will also go into the specific case of this unique issuance, its pricing, value and Wells Fargo’s possible strategies.
Debt, Equity, Either, Neither
Convertible bonds operate as hybrid securities with both debt and equity features: the bondholders can convert the bond into common equity at an agreed conversion price, which usually has a premium over the current price. One way to look at this type of securities is as a straight bond plus a warrant (call option on the stock). The investor receives the potential upside of conversion into equity while protecting downside with cash flow from the coupon payments.
Decision dynamics are very interesting. At maturity, bondholders have the incentive to convert if the conversion value (share price*number of shares converted) is higher than the face value of the bond. Voluntarily bondholders should never convert before maturity because if they wait they can execute the conversion at a higher price (in the case the share price increases) or keep the bond (if the price decreases). On the other hand, the issuers would prefer the conversion to be executed as soon as possible, once the price trigger is reached. Otherwise the value they would have to pay to bondholders would increase while price increases. For this reason the issuers have the incentive to call the bond once the trigger price is reached.
The rationale behind the issuance of convertible bonds has an economic significance that can easily be interpreted by “the market” as a signal. Facing different options of financing, a good, a bad, and a...