In a developing trend, investors can now access opportunities outside of corporate debt and hybrid issues from major banks, where potential returns may be boosted by an embedded call option. Noteholders receive a fixed interest yield up until the first call, where optional conversion into ordinary shares is available at a time before this date.
We view these instruments as suitable for investors who would like equity exposure and upside but want to limit the downside risk. The Bloomberg price details the fair value of the NCCGA convertible note from the NAOS Emerging Opportunities Company, separating the present value of future coupon payments along with par value, plus an attractive conversion option.
Essentially, the option value at around AUD12 per security would need to be discounted by 50% before the fair value = market value. In our opinion, while the NCCGA notes aren’t currently in-the-money given the NCC equity price, there is still a lot of value in the optionality of this security. Post COVID-19, we expect strong portfolio performance and outperformance by the company, which will result in the NCC equity price being pushed higher by demand.
Chart 1. An Example of NCCGA Pricing – Base Case
Source: Bloomberg CB Valuation
The benefits of holding a convertible like NCCGA include:
- As NAOS does not have any secured debt facilities, the NCCGA convertible notes are effectively the most senior in the capital deck, ranking equally amongst themselves above ordinary equity. NAOS gearing (debt/equity) sits below 20%, secured by an investment portfolio valued at well over AUD50m (as of June 2021).
- NAOS operates as a listed investment company (LIC) through a closed-end structure. This means only existing securities can be bought/sold on the secondary market. A disconnect between the share price and net tangible asset value (NTA) of the company can occur that can influence the supply/demand balance. NCC equity was last trading at AUD1.04 or a c.13% discount to the company’s NTA of AUD1.19 (as of 31 January 2022). Importantly, the conversion price for each NCCGA convertible note is linked to the market price of NCC equity, not the NTA of the company.
- Valuable call option. We have assessed the value of the conversion option embedded within each NCCGA convertible note at around AUD12 per security. Using a base case scenario with an underlying share price of AUD1.05, an equity volatility assumption of 21%, and a conversion price of AUD1.15. Note: the option valuation is very sensitive to the assumed volatility given the illiquid nature of ASX-listed micro-cap equities.
- Fixed yield of 4.5%. Holders of NCCGA convertible notes receive interest payments paid semi-annually. Interest payments are non-deferrable and non-discretionary. NAOS will make interest payments using available cash and plus cash flow from performance (dividends/investment income and net profit realisations) of the >AUD50m investment portfolio − consisting of ASX-listed micro-cap equities. With several capital notes nearing their optional exchange date in 2022 (ANZ and CBA to name two), issuers are likely to refinance with a first call date of 2029 at a margin of between 3mbbsw +250-300bps. Thus, the NCCGA convertible notes look attractive value.
Chart 2. Option Valuation Matrix Showing Change in Assumed Volatility and Impact on Theoretical Price
Source: Bloomberg CB Valuation