8.3 PRODUCT MECHANICS AND APPLICATIONS
8.3.3 Buy/write (covered call) securities
Buy/write, or covered call, securities have evolved into an important equity hybrid. These assets are built on the premise that equities can be decomposed into two separate components: one component that pays dividends, and a second one that pays capital gains. Since certain classes of investors may have a preference for one stream of income versus the other, an opportunity exists to sell the underlying equity into an SPE or trust, and allow the vehicle to issue structured securities that represent the individual components of the income stream: the dividend tranche pays all accumulated dividends and a redemption value (also known as a termination claim) that excludes any capital appreciation, while the capital gains tranche pays any accumulated value above the redemption value, but no dividends. These flows are highlighted in Figure 8.4.
Examining this structure in light of the building blocks discussed in Chapter 2, we note that the dividend tranche is precisely equal to a long position in the underlying stock, and a short call struck at the redemption value (as noted in Figure 8.5), while the capital gain tranche is equal to a long call struck at the redemption value. Though writing a covered call generally is considered to be a low-risk strategy (e.g. the investor writing the option has sufficient shares to cover the liability in the event of exercise), the strategy still has risks, including the risk that the security will underperform versus the naked equivalent, i.e. giving up some upside potential and
13A conventional convertible can only be decomposed if it is sold into an SPE or trust, which then issues separate synthetic securities/receipts (or enters into a total return swap) that replicate the economics of each individual component. Such “convertible stripping” is, in fact, a common arbitrage technique, but requires the creation of the intermediation vehicle; decomposition of the bond with warrant requires no additional steps.
$
$
$
Market
Common stock paying dividends and potential capital appreciation
Trust/SPE
Dividend tranche paying dividends and redemption
value
Capital appreciation tranche paying gains above the
redemption value
Investors Investors
Figure 8.4 Two tranches of an equity security
assuming some downside risk that is only partly compensated by the “premium.” Nevertheless, various incarnations of buy/write securities have proven popular with sophisticated investors, as they permit the purchase of a precise risk/investment position that might otherwise be inefficient to create on a standalone basis.
Buy/write securities can be issued via standard underwriting methods or through a special distribution mechanism, and may be issued at a premium or discount to par. Dividends on the
Profit
Loss Short call
Stock price
Covered call (capped return) Long position in stock
Figure 8.5 Covered call tranche
issue are generally payable quarterly, and some issues allow for the transfer of voting rights to the investor. Principal redemption is a function of the stock price: if the stock price is less than (or equal to) the cap price determined at launch, the investor receives one share per unit;
if it is greater than the cap, the investor receives shares at a rate determined by the ratio of the cap price to the value of the common stock. Since the value is capped, the number of shares received declines as the stock price rises.
In the section that follows we consider several types of the buy/write security, including PRIMES and SCORES, PERCS, and synthetic PERCS. As noted earlier in the chapter, PERCS and certain synthetic PERCS result in the issuance of new equity upon exercise; PRIMES and SCORES, and various classes of synthetic PERCS result only in the reallocation of existing equity, and are thus nondilutive (indeed, such securities can be considered forms of the equity- linked structured note we describe in Chapter 5).
PRIMES and SCORES
The inaugural buy/write security appeared in 1983 via the Americus Trust, a special trust established to divide securities into separate cash streams.14 Though the PRIME/SCORE product is no longer issued, it is worth investigating its design, as it paved the way for a new generation of similar buy/write structures.
The Americus Trust was created as a redeemable unit investment trust, with units that could be split into a PRIME component (Prescribed Right to Income and Maximum Equity) and a SCORE component (Special Claim On Residual Equity); the two components could also be recombined at any time. The termination claim (strike) on the PRIME unit was equal to a dollar limit on the potential for capital appreciation: all value up to the termination claim, plus dividends, was distributed to investors in the PRIME unit, while all value in excess of the termination claim was directed to investors in the SCORE unit. The two units were thus equivalent to the dividend and capital appreciation securities noted in Figure 8.5 (i.e. PRIME as a covered call and SCORE as a long-dated call warrant, meaning the PRIME investor was long the stock and short the SCORE). Investors tendered shares into the trust and received a unit for each share tendered (with specific expiration and termination claim); the units could then be split into the two different components. Each unit had a five-year maturity and a strike set at approximately 25 % above issue price, and was collateralized by the underlying shares, which were held by a trustee. If the common stock price ended below the termination claim price, the PRIME investor received a share of stock, along with cash dividends, the dividend received deduction, and full voting rights; the SCORE investor’s contract expired worthless. As the stock price traded further below the termination claim price, the PRIME traded more like equity, and as it rose above the termination claim price, it became more “debt like”; indeed, as the stock price moved well above the termination claim, the PRIME became a discount bond, paying a below-market coupon. (This behavior is, of course, precisely the reverse of a convertible’s, which is logical, since the PRIME featured an embedded short, rather than long, call option.)15If, however, the stock price ended above the termination claim price, the
14The first deal, launched on AT&T stock, was arranged by Kidder Peabody; a second trust was floated by Furman Selz on Exxon stock in 1985. Alex Brown then decided to take a leading role by negotiating the distribution rights for the remaining trusts that had been filed with the SEC, and floated deals on a number of stocks in 1986 and 1987. The October 1987 stock market crash curtailed further activity, and new products, such as PERCS, eventually emerged to replace the role filled by the Americus Trust.
15From a theoretical perspective, an out-of-the-money SCORE and a corporate bond floated by the same issuer could be repackaged to create a synthetic convertible bond.
PRIME holder received a fractional portion of shares, equal to the termination claim divided by the closing price. The SCORE investor, in turn, received value equal to the closing price minus the termination claim, divided by the closing price. The SCORE could be exercised at any time by combining it with a PRIME and submitting it to the trustee in exchange for a share of stock.16 SCORES were nondilutive (e.g. third party warrants rather than issuer warrants, as they did not result in the creation of new equity), but were considered by regulators to be securities rather than derivatives; the long-dated nature of the transactions gave investors the opportunity to purchase long-dated call options that were otherwise unavailable in the market.17The exchange-listed PRIME and SCORE issues were of limited size, meaning they were prone to illiquidity.
PERCS and synthetic PERCS
The next generation of the buy/write structure appeared in 1988, when Morgan Stanley launched an inaugural issue of PERCS (Preference Equity Redemption Cumulative Stock) for Avon.
Though PERCS evolved naturally from the PRIME/SCORE, the security is structurally dif- ferent in several key respects: the issuer, rather than the investor, holds the equity option, and the exercise of the option results in the creation of new shares, and is thus dilutive.
PERCS are buy/write securities based on mandatory convertible preferred stock, and rank senior only to the issuer’s common stock.18As the name implies, the mandatory convertible requires the issuer to convert into common stock at a specific price and time, which resolves some of the uncertainty related to the funding exercise; indeed, the investor has no right or option over conversion. An investor purchasing a PERCS holds a synthetic instrument comprised of a long position in preferred stock, and a short call option that allows the issuer to convert into common stock once the conversion price is reached;19 as noted, the long call option is held by the issuer, rather than a different class of investors (as in the typical buy/write security).
The investor receives an above-market dividend on the preferred in exchange for granting the right; this is equal to the premium payment amortized over many periods (rather than upfront, as is typical in a covered call transaction). The investor thus faces full capital depreciation and limited appreciation in exchange for a higher return. PERCS are often launched for issuers with common stock that appears to be undervalued. The conversion price generally is set at 30–45 % above the common equity price at the time of launch, and two conversion features are usually incorporated: a mandatory conversion clause that requires conversion on a 1:1 basis by some future date, and a fractional conversion clause that permits conversion on less than a 1:1 basis as soon as the conversion price is reached.20As the stock price of the issuer rises, fewer shares are needed to redeem the PERCS; this can be regarded as a form of reverse dilution.
Note that early redemption does not eliminate the issuer’s obligation to pay the investor the entire premium that is due.
16Since a share of common stock held by the trustee backed the SCORE, the SCORE investor was not exposed to the counterparty risk of the PRIME investor (i.e. the option seller).
17Though the Chicago Board Options Exchange listed LEAPS, or Long-term Equity Anticipation Securities, as long-dated options, the number of issues was limited and the exercise prices and styles were restricted. Long-dated OTC contracts were expensive, and were limited to the sophisticated institutional investor market.
18Though PERCS are similar in design to the original Americus Trust securities, they form part of the issuing company’s capital structure (just as a convertible or bond with warrant might).
19In fact, this structure can be viewed as a form of a covered call or buy/write, with the investor delivering shares of preferred, rather than common, stock if the issuer exercises the call option.
20Since the offering price of the PERCS is set equal to the common stock at issue date, the issuer essentially sells equity at a price that is no lower than the price at issue date; any subsequent rise in the price from that point on simply decreases dilution.
The value of the PERCS is a direct function of the premium/discount of the security versus the common stock and the present value of the enhanced dividend stream. Stated differently, the value of the embedded call retained by the issuer is equal to the stock price, less the PERCS price, plus the present value of expected dividends. PERCS typically are callable; however, since investors rely on the enhanced dividends over time to generate their returns, the call price must be set at some appropriate premium to par value (i.e. it must be a function of the remaining unaccrued call premium due). In fact, the call price generally is equal to a cap price of 30–50 % above the common stock price at launch, plus expected incremental dividends as of the issue date (declining over time as the incremental amount accrues and converges to the cap price). Though PERCS are similar to common shares, ultimately they feature several key differences: PERCS rank senior to common shares in the event of bankruptcy, they are capped on the upside, and they pay an enhanced dividend in exchange for the cap; however, like common stock, PERCS can be an expensive form of funding, and dividend payments are not deductible.
Following the success of PERCS, various intermediaries began creating their own buy/write structures, many of them following the synthetic PRIME/SCORE/PERCS model. In fact, pro- prietary buy/write debt obligations, such as Debt Exchangable for Common Stock, Dividend- enhanced Convertible securities, Common-linked Higher Income Participation securities, Yield-enhanced Equity-linked securities, and so forth, emerged in the mid- to late 1990s and are still issued to the present time.21Most carry three to five year maturities, and 30–50 % strike caps, but pay quarterly coupons rather than dividends, and are noncallable and nondilutive.
Conventional and synthetic buy/writes are listed and traded on a major exchange; secondary liquidity is best described as moderate, with most activity occurring in the weeks and months following initial issuance.