Joined: Jun 2007
Location: Dallas Texas
Convertible Bonds: How do they work
All of this talk about Goldman Sachs and Cramer and Converts... My head is spinning. I have always been a straight up stock man. Now that all of this has surfaced, I have been looking in to how the Bonds work. Please pardon me if I ramble, I am still working it out in my head.
Convertible bonds generally have a lower interest rate, hence the 2.5% coupon rate that the GS bonds hold.
Convertible bonds are traded somewhat like stocks, but are more stable. In the case of GS and Sirius XM, the bonds are UNSECURED, meaning that if Sirius XM filed bankruptcy, GS is screwed. However, the fact that they are unsecured also means that they can sell for less than their value. Example: A $1,000 XM Bond is worth $1000 when it comes to convert, regardless of the number of shares or strike price or anythign else. As long as Sirius XM does not default on the loan (which Mel states is "a rediculous proposition.") then you will get your money back. The play comes in the interest payments, and the convertible rate. But as long as there is no default, your money is SAFE. The issue with Sirius XM is that they is a possibility for default. Now, that $1000 bond is selling on the streets for $950. Anyone who buys it is looking at a $50 profit.. as long as there is no default. (please keep in mind, these numbers are fictitious and made up...)
If GS has been buying these for the last 18 months, perhaps it is because they KNOW the company is stable enough to not default on it. Perhaps this is what Cramer is seeing as well. Perhaps they KNOW that there is no way that the company can reach the $4.50 strike price. Why not bash the stock, make a killing on the Arb play through our shorted shares, AND keep buying the bonds at a discount. It is a win-win situation for them. Remember, these are FEBRUARY converts. That is a short time to make a lot of money. Slowly (and quietly) cover our short position while the stock is hammered, and then come february, turn in our bonds for our tiny profit.
Does any of this seem plausible?