convertible security

Case Study

Convertible securities sometimes sport unusual features that can make these investments difficult to evaluate. In July 2001 Norvellus Systems, a manufacturer of semiconductor production equipment, issued unrated zero-coupon bonds convertible into shares of the firm's common stock at a price of $76.36 per share, a 50%premium to the market price. Zero-coupon debt securities are popular with many borrowers and investors, so the lack of a coupon on the issue was not especially unusual. The unique feature was the issue price of the bonds, which were sold at face value rather than a discount to face value. Virtually all zero-coupon bonds are issued at a discount to par value, thus attracting buyers who are assured of earning a positive return in the event the securities are held to maturity. To attract investors to this unique bond Norvellus agreed to allow bondholders to redeem their securities at par value at the end of one year. In other words, buyers of the securities were guaranteed they would be able to recoup their original investment at the end of a year if they were unhappy with the firm's stock price performance. During the first year Norvellus invested proceeds of the bond issue in U.S. government securities. The government securities collateralized its bonds and allowed the firm to earn interest income at the same time it was not paying interest to bondholders who had purchased the firm's debt. Holders of the convertibles who decided not to redeem the bonds at the end of the first year held a debt security that could be converted into common stock but paid no interest.