This excerpt is taken from an article titled “Caywood Looks for Convertibles,” which appeared in the January 13, 1992, issue of BondWeek, p. 7:

Caywood Christian Capital Management will invest new money in its $400 million high-yield portfolio in “busted convertibles,” double- and triple-B rated convertible bonds of companies . . . , said James Caywood, CEO. Caywood likes these convertibles as they trade at discounts and are unlikely to be called, he said.

What is a busted convertible?

What is a mandatory convertible?

Upon exercise of the conversion option for a convertible bond, all issuers must exchange shares of stock for the bond. Explain whether you agree or disagree.

Tracy Company, a manufacturer of air conditioners, sold 100 units to Thomas Company on November 17, 2021. The units have a list price of $500 each, but Thomas was given a 30% trade discount. The terms of the sale were 2/10, n/30. Thomas uses a perpetual inventory system.

1. Prepare the journal entries to record the (a) purchase by Thomas on November 17 and (b) payment on November 26, 2021. Thomas uses the gross method of accounting for purchase discounts.
2. Prepare the journal entry for the payment, assuming instead that it was made on December 15, 2021.
3. Repeat requirements 1 and 2 using the net method of accounting for purchase discounts.

What is a cash flow arbitrage strategy involving convertible bonds?

What is the difference between a busted convertible and a distressed convertible?

Why is a volatility trading strategy considered to be a nondirectional strategy?

The following quotes are from Mihir Bhattacharya, “Convertible Securities and Their Valuation,” Chapter 51 in Frank J. Fabozzi (ed.), The Handbook of Fixed Income Securities, 6th ed. (New York: McGraw-Hill, 2001).

“Convertibles have equity and interest rate options, and occasionally, currency options, embedded in them. Issuers and investors are becoming even more aware that option valuation is driven by, among other factors: (a) equity volatility, (b) interest-rate volatility, and (c) spread volatility. In some situations the embedded options may easily be separated and valued. However, in the vast majority of cases, they interact with each other and so prove difficult, if not impossible, to separate. Investors should be aware of the inherent danger of attempting to value the embedded options as if they were separable options.” Explain why the factors mentioned in the quote affect the value of a convertible bond and why the factors interact.

The following quotes are from Mihir Bhattacharya, “Convertible Securities and Their Valuation,” Chapter 51 in Frank J. Fabozzi (ed.), The Handbook of Fixed Income Securities, 6th ed. (New York: McGraw-Hill, 2001).

“Increased debt market volatility has driven home the point of duration risk inherent in any security with a fixed income component, including converts. The increased volatility of the spreads (over Treasury or other interest rate benchmarks) has heightened investor sensitivity to the reliability of the fixed income floor or bond value of the convert.” What message is the author trying to convey to investors?

Suppose that the price of the underlying stock for a convertible bond is considerably higher than the conversion price. What would you expect that convertible bond’s delta to be?

Why would you expect that a distressed convertible would have a delta of zero?

How many shares of the stock must be shorted in order to create a market-neutral position by holding the convertible bond and shorting the stock?

Suppose that a convertible bond has a conversion ratio of 20 and a delta of 0.70. For a price change of $0.125 for the stock price per share, what is the approximate change in the convertible bond’s value?

Explain the two ways in which a bank can sell its position in a syndicated loan.