Are you interviewing for a fixed income analyst or researcher? Brush up on your valuation skills before attending the interview. Below is a sample valuation of a corporate bond issued by Chiron Corporation.
Basic Bond Information:
The bond analyzed in this example was issued by Chiron Corp and is graded A- by S&P, meaning it is considered a safer bond to invest in. The bond is currently undervalued and would be a good buy, and matures on 10/28/22. The bond is convertible and the conversion ratio is 14.925. The coupon is 2.75% and the current stock price is 31.64.
Analysis:
First, I calculated the present value of the bond. Merrill- Lynch computes a theoretical value of 97.28, which takes into account the option price currently available on the bond. In this case, the bond is being offered at a discount which is why I recommend it, especially considering its rating by S&P.
I determined that the number of shares to hedge against an upward raise in the stock price is 11 shares, outlined below:
Convertible price = $1,000
Stock price = $31.64
Conversion premium = 5.88%
Stock price conversion premium = $33.50
Option delta = 0.377
Number of shares to short = 11.25
(Convertible Price/ Conversion Premium)*Option Delta
I assumed a 30% rise and decline in the stock price because the annual volatility is 30%. Below outlines the annualized returns based upon hedging the bond through shorting 11 shares and purchasing the bond now. Even if the stock declines in price by 30%, the bond holder would still make a minor return, and on the upside will make a significant return of 23.27%. Thus, the risk of purchasing this bond is low because with the hedge you will not loose any money and have the possibility of making significant returns. My calculations are shown below:
No Change in Stock Price:
30% Rise in Stock Price:
Interest earned on short sale proceeds= (Number of short shares*share price*coupon rate)
30% Decline in Stock Price:
Recommendation:
As this bond is rated A-, I feel the default risk is low. The bond is undervalued and presently a good buy. I recommend this to clients who do not want to take on a lot of risk however would like the possibility of higher returns. The volatility of the stock is high, but I feel this is a trend in the healthcare industry and is to be expected of a company of this size. I recommend a client considering purchasing this bond purchase 11 shares of options to hedge against the risk of the stock decreasing significantly.
Below is a convertible bond calculator which is available at cfo.com, and I plugged in the data from Chiron Corp to determine the conversion price per share and other outputs. Also, should you want more information about options (which is discussed in this article as a way to hedge against risk) check out cboe.com. The Chicago Board Options Exchange has a myriad of fantastic tutorials on options, many of which are available for free online.
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